2013-12-18 / Business News

Commodities futures explained

MONEY & INVESTING
jeannetteSHOWALTER, CFA

There is much confusion about the various types of commodities related investment vehicles. They sound alike but have scant similarity in construction, function and performance.

Commodities futures and managed futures (including financial index futures) are sold by commodities brokers. ETFs, managed futures mutual funds, and certain commodity indices are sold by stock brokers.

Commodities futures are contracts to buy or sell, at a predetermined price and date, a set amount of a commodity including: grains, meats, metals, energies, softs, stock indexes, financials and currencies. Futures’ liquidity and price discovery is found in worldwide markets that trade 24/7.

Commodities futures have beneficial taxation treatment in that a large percentage of any gain is designated as longterm capital gain regardless of how short a period of time it was owned/held.

The commodities futures contract is a leveraged contract. It allows a small amount of capital to carry a very large contract position. They are sold by commodities brokers who earn a commission.

Most importantly and uniquely, they are not a “long biased’ market. It is a zero sum market in that every purchase of a futures ccontract o“ (or a “long”) is balanced by a sale of a futures contract (or a corresponding “short

Ta commodities-related products.”) This compares to equities markets, which are “long e. ne biased” ( g. owners selling to new owners.) In equity corrections/crashes, there can be little liquidity as all are attempting to sell in unison.

Commodities indices are an index average of certain commodity prices based on underlying futures prices, either for a broad base or a specific subset of commodities.

ETFs are investment funds traded on a stock exchange. The funds can specialize in equities, bonds, commoditiesrelated products, etc. Commodity ETFs are intended to track an underlying single commodity or several commodities futures contracts.

Both commodity indices and ETFs became popular in the wake of explosive growth in developing countries and their need for basic commodities. Stockbrokers wanted to offer commodity-like products to their clients yet are not licensed to sell commodities. Commodity indices and ETFs were created/promoted under the headers of 1) diversification and 2) inflation hedging. Yet, the prices of commodity ETFs crashed (and were illiquid) in 2008-2009 alongside equities. Since 2008, inflation has been a non-issue and most long only indices/ETFs have performed abysmally in this deflation.

ETFs have added fees for executive compensation, marketing and administration. They are notorious for price slippage in their commodities futures execution. ETFs lack the preferential tax treatment of commodities futures.

Managed futures are a portfolio of long and short futures positions traded by a commodities trading adviser or CTA. Most CTAs use layers (upon layers) of portfolio management techniques to manage the risk of each commodity futures position and the overall portfolio’s risk. At the client’s discretion, the portfolio’s leverage can be lowered by capitalizing the account with additional equity.

Uniquely, managed futures can lower overall portfolio risk of a traditional stock/bond portfolio while increasing overall portfolio return. It has capacity to adjust to changing economic conditions (e.g., inflation or deflation) and suddenly changing market conditions (e.g., equity crashes.) For many trend following CTAs, there is no presupposing what markets will do; their algo systems react to existing trends across: grains, metals, energies, stock indexes, financials, currencies, etc. Unlike ETFs which were shown to be positively correlated with equities and of little value in an equity crash, managed futures offers a near zero correlation with equities in normal times and, most importantly, a nearly perfect negative correlation in times of equity crisis.

Managed futures are important to equity investors who know that equity crises cannot be precisely timed and that the Fed is undertaking Herculean monetary feats to generate inflation.

Managed futures (mutual) funds are funds that sounds like managed futures — but they aren’t. By securities law, any fund sold by equities brokers must qualify as securities. Based on multiple prospectuses of managed futures mutual funds, these funds have frequently placed 75 percent of the portfolio in securities and have placed 25 percent in an offshore subsidiary that manages the commodities-related portion (either through a CTA or ETFs and indices). In sum and substance, smart lawyers have found a way to create another commodities related product with a complicatedstructure such that equity brokers can sell it.

In summary, it is managed futures that can have the capacity to perform well in crises, retains the beneficial tax aspects, trades in markets with world wide price discovery and liquidity, does not charge layers of executive, administration and marketing fees, and exactly tracks the prices of commodities futures. ¦

— Jeannette Showalter, CFA is a commodities broker with Worldwide Futures Systems. Find her on Facebook at Jeannette Showalter, CFA.

— Trading futures and options on futures and Forex transactions involve substantial risk of loss and may not be suitable for all investors. You should carefully consider whether trading is suitable for you in light of your circumstances, knowledge and financial resources. You may lose all or more of your initial investment. Opinions, market data and recommendations are subject to change at any time.

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