10 Investment Vehicles for Commodities
Because the commodities markets are so wide and deep, you have a number of investment vehicles to access these markets. A common misconception among investors is that you can only trade commodities by opening a futures account. While the futures markets certainly provide an avenue into the commodities markets, you have other tools at your disposal. Following are the ten most important investment vehicles.
Futures Commission Merchant
Opening an account with a Futures Commission Merchant (FCM) is the most direct way for you to invest in commodities through the futures markets. An FCM is registered with the National Futures Association (NFA) and its activities are monitored by the Commodity Futures Trading Commission (CFTC). When you open an account with an FCM, you can actually trade futures contracts, options, and other derivative products directly through the main commodity exchanges. Your orders are sometimes routed electronically or are placed during the open outcry trading session. However, you should only open an account with an FCM if you have a solid grasp of trading futures and options.
Commodity Trading Advisor
A Commodity Trading Advisor (CTA) is authorized by the CFTC and the NFA to trade on behalf of individual clients in the futures markets. The CTA is a registered investment professional who has a good grasp of the concepts in the futures markets. However, before you invest through a CTA, you should research their track record and investment philosophy.
Commodity Pool Operator
The Commodity Pool Operator (CPO) is similar to the CTA in that she has the authority to invest on behalf of clients in the futures markets. The biggest difference is that CPOs are allowed to “pool” client accounts under one giant account and enter the markets en masse. The pooling of client funds offers two advantages: It increases the purchasing power of the fund, and it provides additional leverage. In addition, because a CPO is usually registered as a company, you can only lose your principal (in case things go wrong). In other words, you won’t get any margin calls and owe the exchange money.
Integrated commodity companies
The equity markets offer a way for you to get exposure to commodities by investing in companies that process these natural resources. Some of these companies include large, integrated commodity-processing companies. In the energy space, these are companies like ExxonMobil (NYSE: XOM) and Total (NYSE: TOT) that have exposure to crude oil and natural gas in both the exploration and distribution phase of the supply chain.
In the metals complex, companies like Rio Tinto (NYSE: TRP) and BHP Billiton (NYSE: BHP) mine minerals and metals as varied as palladium and nickel. These integrated mining companies have operations throughout the globe.
Specialized commodity companies
If you want to get exposure to a specific commodity through the equity markets, you can always invest in specialized commodity companies. These companies focus on either one commodity or on one aspect of the supply chain. For example, oil tanker operators focus on transporting crude oil from Point A to Point B — that’s the extent of their activities. Other such companies include Starbucks (NASDAQ: SBUX), which focuses strictly on selling and marketing coffee-related products. These are good companies to invest in if you want exposure to a specific commodity through the equity markets.
Master Limited Partnerships
Master Limited Partnerships (MLPs) are hybrid investment vehicles that invest in energy infrastructure. They are in fact private partnerships that trade on public exchanges, just like stocks. This unique combination provides several advantages.
Because the MLP is a partnership, it has tremendous tax advantages because it doesn’t pay taxes on the corporate level, only on the individual level. It’s therefore not subject to the double taxation that many corporations are subject to.
Its mandate is to distribute practically all its cash flow directly to shareholders. It’s therefore not uncommon to have an MLP return $3 or $4 per unit owned.
Exchange Traded Funds
Since they first emerged on the scene a few years ago, the popularity of Exchange Traded Funds (ETFs) has soared. And for good reason. They’re privately run funds that trade on a public exchange, just like stocks. This ease-of-use has directly contributed to their popularity among investors. A number of ETFs have been introduced in recent years, which track the performance of commodity-related assets, such as gold, silver, and crude oil. But it’s not just individual commodities that are now tracked by ETFs. Commodity indexes, such as the Deutsche Bank Liquid Commodity Index (AMEX: DBC), also have ETFs that track their performance.
Commodity mutual funds
Investors who are used to investing in mutual funds will enjoy knowing that a number of mutual funds invest directly in commodities. Two of the biggest such mutual funds are the PIMCO commodity fund and the Oppenheimer fund.
Some funds seek to mirror the performance of various commodity benchmarks, while others invest in companies that process commodities.
A commodity index acts a lot like a stock index: It tracks a group of securities for benchmarking and investing purposes. Commodity indexes are constructed and offered by different financial institutions, such as Goldman Sachs and Standard & Poor’s, and they follow different construction methodologies. As such, the performance of the indexes — there are currently five — is different across the board. Most of these indexes can be tracked either through the futures markets or through ETFs.
Emerging market funds
Due to geographical happenstance, commodities are scattered across the globe. No single country dominates all commodities across the board. However, a few countries do dominate specific commodities. South Africa, for instance, has the largest reserves of gold in the world, Saudi Arabia has the largest oil reserves, and Russia has the biggest palladium reserves. As the demand for commodities increases, the economies of some of these emerging markets have been soaring. One way to play the commodities boom is by opening up your portfolio to emerging market funds.