When it comes to investing in commodities, there are two ways to gain direct exposure to this asset class. The first is through commodity futures, and the second is through ownership of the commodity itself.
The first way is through direct ownership of futures contracts in a futures account or through ownership of shares in a mutual fund or exchange-traded fund (ETF) that in turn holds commodity futures contracts. There are some downsides with this way of ownership, especially for long-term investing. The first issue is with what is called “contango” in the futures market. This is a very common occurrence in futures markets when the price of the contract set to expire next (the “front month”) is lower than the price of a contract or contracts set to expire further in the future. Without going into too much detail, the net result of this “contango” is that over time, your investment account will “under-perform” the commodity or commodities you are trying to gain exposure to. The second issue with long-term futures-based investing is the security of the futures contracts themselves. Futures accounts are not federally insured like regular brokerage accounts, which means that in the case of theft from your account by your futures broker (as has recently happened at MF Global and Peregrine Financial), you may only be able to recover a fraction of your money, if at all.
The second way to invest directly in commodities is through ownership of the physical commodity itself. This may be done by personally storing the commodity, or by ownership of a contract with or shares in an entity that stores the commodity for you. Many people choose this second route for convenience and security. At the moment the only commodities I’m aware of that can be owned in this manner are precious metals (gold, silver, platinum, palladium, etc.), as their storage costs are relatively low as they take up much less space per dollar’s worth compared to other commodities. Among the most convenient and affordable methods of this “remote storage” is through funds that offer ownership through shares traded on global stock exchanges. These include exchange-traded funds (ETFs) and closed-end funds (CEFs).
Investing in Precious Metals
Historically, during times of commodities “bull markets”, precious metals have tended to out-perform other commodities because they are easy to store and easy to buy and sell (also known as “liquidity”).
But additionally to gaining direct exposure to precious metals as we discussed previously, investors can also get indirect exposure to the price of metals by investing in companies that own and conduct mining operations. This method of investing carries higher risk than investing directly in precious metals, but along with higher risk comes higher possible reward.
Historically, particularly in Latin American countries, where many gold and particularly many silver mines are located, during times of severe economic stress and inflation when the value of these metals often increases significantly, governments have taken ownership of mines by force in order to continue funding themselves. Alternatively, special taxes can be levied against profitable mines. In both these cases shares in the company or companies operating the mines can lose most or all of their value. Effectively, the mines and shareholders are punished for their own success by desperate governments.
Another risk with holding shares in mining companies is the share price’s “leverage” to the price of a metal. For example, let’s suppose silver is $30 per ounce. Let’s say investor “A” buys $1000 worth of a closed-end silver fund that essentially exactly tracks the price of silver. Investor “B” buys $1000 worth of shares in a silver mining company that can take the metal out of the ground for $20 per ounce, making $10 profit per ounce of silver mined. Let’s say the price of silver drops to $20 per ounce. Investor A’s investments will now be worth $667 as the silver price has dropped by 1/3. However with investor B, if mining cost is still $20 per ounce, he is now holding shares in a company that cannot take silver out of the ground for less than what they can sell it for (especially if they did not use silver-price hedging strategies which most miners today do not). If this situation persists long enough, the company will have to declare bankruptcy, which often completely wipes out the value of shares in the company. Investor A is down 33%. But investor B is down 100%.
The other side of this risk in mining shares is the greater possible reward. Let’s say in the above example, instead of dropping from $30 to $20, the price of silver rises to $60. Investor A will have doubled his money to $2000. Let’s say again the cost of mining for investor B’s company is the same at $20 an ounce. With this hypothetical silver price rise, the company’s profitability just went from $10 per ounce, to $40 per ounce; a four-fold increase. What often happens in this situation, especially if investors think this higher profitability is sustainable, is a corresponding rise in share price; four-fold in this case. Investor B now has $4000, double that of investor A.
Due to this higher risk profile of mining stocks, many investors hold them as only a portion of their precious metals holdings, with the rest in instruments with direct exposure to the price of the metal/s.
When it comes to choosing which specific mining companies to invest in, this is where the commonly-heard advice of “diversification” is particularly appropriate. Diversifying mining investments primarily across larger, established companies can limit the risk of a single region or company adversely affecting one’s portfolio. It is true that limiting the majority of mining investment to larger miners can limit the upside of small mining and exploration companies whose share prices explode when they come upon a large cache of metal, but it also limits the downside of the countless number of these companies that end up in bankruptcy.
A popular way of achieving investment diversification is with mutual funds, which pool the money of a large number of investors and invest it according to the aim of the particular fund. This allows individual investors to achieve a level of diversification that would otherwise incur prohibitive transaction costs. Available funds in precious metals mining include traditional mutual funds and the similar exchange-traded funds or ETFs.