UPDATE: Since we ran this report, much has changed in the world of commodities. You can find an updated article here.
Americans are being hit by rising inflation and the subsequent explosion in commodity prices where it hurts most—at gas stations and grocery stores. Right alongside this growth have been the opportunities available to investors to hedge these rising prices by way of exchange traded funds (ETFs).
A barrel of oil now sells for $133, which means you’re paying around $3.80 for a gallon of gas. That gallon of milk you bought for $3.87 a few days ago sold for $3.20 in 2006; and the price for a dozen eggs rose from $1.45 to $2.18 over the same time.
You name the commodity, if the world consumes it or relies on it to keep the gargantuan global economic wheels turning, it probably costs more today than it did yesterday. It may cost even more tomorrow. Take a look at the price of oil and gold over the past year:
ETFs Take the Mystery Out of Commodity InvestingAs you can see, commodities across the board have been increasing in price as supply struggles to keep up with growing global demand. We may be shoveling out more and more money to pay for life’s essentials, but there’s no reason investors that shouldn’t have the opportunity to profit from and hedge these price spikes, too.
This hasn’t always been the case, however.
Before the influx of ETFs, most individual investors were simply left out in the cold.
For decades, commodities remained the exclusive domain of professional traders, large companies and hedge funds—and for good reason.
Futures trading requires an in-depth understanding of economic trends and the ability to anticipate the impact those trends will have on the cost of goods, as well as the willingness to monitor trading activity on a daily basis.
It’s not for the faint-of-heart.
Risk and reward are high, but prior to commodities ETFs, you had to know the “game” intimately.
Now, investors have the most simple and diversified tool at their disposal to access commodities.
Understanding futures contracts and their intricacies isn’t a prerequisite for diving in. The fund takes care of that for you. However, there are still things investors need to know. Commodity ETFs come in various shapes and sizes, from gold to soybeans to cattle. Some hold futures; others hold stock in companies involved in the making of commodities. Here’s an explanation of each:
- Physical Commodities: The most direct way to own a commodity is to actually buy the commodity. But the hassle of buying, storing and selling gold is not very practical. So, you can buy an ETF that buys gold, and your shares give you partial ownership of the physical metal.
- Individual Commodity Futures: The main factor determining the performance of an ETF linked to commodity futures is changes in the spot price of the underlying commodity. The “spot” price is the current price of the commodity and as it changes, so does the value of the future contracts based on it. If the spot price goes up, the value of the futures contracts goes up, and so does the value of a share of an ETF holding these futures. One aspect to keep in mind with respect to this type of ETF: Any gains or losses generated throughout the year within the fund are taxed as 60% long-term and 40% short-term gains, regardless of how long the contracts were held. At current rates, this works out to a maximum 23% capital gains rate; higher than stocks but lower than collectibles.
- Commodity Indexes:ETFs linked to commodity indexes give investors the ability to diversify their holdings. For example, you can invest in a broad-based ETF to give you plays on individual commodities such as soybeans, corn, sugar and wheat; or you can buy an ETF that gives you pieces of agriculture, energy and metals.
- Commodity Equities:Finally, ETFs linked to commodity equities are those that hold a basket of companies that make or process a commodity. These have a different risk/return profile than commodities futures alone. They expose the investor to company risk in addition to issues related to the specific commodity. This can be good or bad. Investors have the additional upside of appreciation in individual company stocks, but prices of company stock also can go down in response to company-specific events.
Now that you know the inner workings of commodity ETFs, let’s dig into the nitty-gritty: the actual commodities, what’s making them tick and which ETFs are available to investors.
Costs for energy and land, the two biggest factors for affecting agricultural pricing, have risen sharply in the past several years.
More than 6 billion people roam the planet right now, and on continents such as Africa, millions of people are already starving. Hoarding of one of the most basic food substances—rice—is even becoming commonplace in many areas of the world.
By 2020, it is expected that there will be 3 billion additional people in the world. This means we’re essentially going to have to figure out how to double global agriculture production over the next 13 years, just to meet the population growth of the world.
Many politicians, economists and academics blame growing middle classes in China and India for slowly adopting more Western diets (which is probably just a nicer way of saying “burgers, fries and milkshakes”).
The average American eats 3,770 calories a day. It’s the highest caloric intake in the world. India consumes 2,440 a day per capita.
Turning to the link between agriculture and energy…ethanol, made from corn and to a lesser extent, sugar, continues to be the government’s “alternative energy source of choice.”
So, the agriculture community continues to promote it as a way to decrease U.S. dependence on foreign oil. The United States and other countries have set aggressive goals for ethanol production; this will result in higher demand for agricultural products, especially corn.
Many of the agricultural commodities have been on futures exchanges since the dawn of time and are some of the most active markets to trade.
Commodities in this category include both raw and processed goods. Some of the agricultural commodities most in demand are: Corn, soybeans, wheat, coffee, cocoa, sugar, cotton, cattle and hogs.
Agricultural ETFs/ETNs to Consider