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Investing in Raw Material Commodities is Easy Now: How to Avoid Risks and Gain from Opportunities

The early raw material commodity exchanges mainly traded agricultural raw material commodities. Until recently, these exchanges were basically set up for producers and consumers of basic raw materials. Buy or sell these raw materials to hedge risks. Today, financial investors are major players in the raw commodity market.

As far as the past situation is concerned, the only feasible way to invest in raw material commodities, but do not want to purchase or promise to purchase spot assets, is usually to indirectly invest in the liabilities or equity of raw material commodity production companies or distribution companies. However, this investment method involves not only the exposure of raw materials and commodities, but also the risk of the target enterprise. For example, if a zinc mining company’s costs are too high, corporate governance is poor, a zinc pit is underperforming or the mine is located in a country with an unfavorable business environment or conditions (e.g. bad weather or supply disruptions due to labor protests, etc.) , then even if the zinc price rises, the company’s operating performance may still be unsatisfactory. In addition, investors also have to bear financial market risks, because even if the price of raw materials rises, if the current stock market is in a short period, the stocks of mining companies may still fall. (But this situation is not common, because raw material commodities share many of the same price drivers as stock prices.)

The difficulty of direct investment in raw material commodities is that the trading volume of the raw material commodity market has been very light for many years, so the price volatility is very high, and due to the lack of market depth, the price is also easily manipulated by specific forces. However, from the end of the 1990s to 2010, as the price of raw material commodities began to rise, more and more complex financial products continued to spring up. In other words, investors can invest more directly in raw material commodities The tools in the market have increased significantly, and the associated transaction costs have also been greatly reduced.

Raw materials and commodity transactions are mostly carried out through the counter market (over-the-counter, there is no formal exchange or trading hall here, and all transactions are completed through telephone or electronic platforms), so the degree of supervision of these transactions is not high.

However, during the period from 2005 to 2010, due to the spiral increase in commodity prices and the lingering fears of the financial crisis in 2008, the outside world began to worry that speculators would become more influential in the market. As a result, the voices for strengthening supervision are increasing day by day. Some people even called for a complete ban on investment transactions in specific raw material commodities, especially agricultural raw material commodities that are prone to political and social sensitivities. They worry that fluctuations in food prices and high energy prices will have a negative impact on low-income or poor families. This in turn makes it harder to improve global poverty levels. In the years following the financial crisis, the U.S. Commodity Futures Trading Commission (CFTC) and the European Commission (European Commission) implemented more stringent supervision of the commodity futures market for raw materials. Trading volumes increased.

◎ Futures market

The earliest raw commodity financial instruments to develop were forwards and futures, markets designed to give grain or metal producers more certainty about the prices that would be traded in the future. Of course, with these markets, consumers of raw material commodities can also lock in the purchase price in advance, and thus better set their budgets.

However, most raw commodity futures trading today comes from financial investors who do not need to use raw materials. Most futures contracts are settled in cash rather than physical delivery. This reduces the need for futures exchanges to store physical objects (in exchange-operated warehouses) as collateral. From the futures contract, the precise attributes and storage locations of the underlying commodities can be seen in detail and in detail.

Once an investor buys a certain raw material commodity futures, it is equivalent to betting that the commodity will reach a certain expected price at a specific point in time. If the futures price curve is a downward sloping curve, it means that the expected price of the raw material commodity in the next three to six months will be lower than the current spot price. Such a market is called backwardation. In this scenario, producers may choose to reduce inventories due to concerns about lower selling prices in the future. If the futures price curve is an upward sloping curve, it means that the expected price in the next six months is higher than the spot price. This kind of market is called contango. It is generally believed that the futures market can perform the price discovery function for the spot market.

The total remuneration that investors can get from investing in raw material commodity futures is composed of three elements, which some people call “spot, rollover and mortgage remuneration”.

Spot Compensation: This is the indicator of the spot price change of the raw material commodity.

Rollover remuneration: the remuneration obtained by selling the near-term futures contract (the futures contract closest to the settlement date) before it expires and reinvesting the obtained price into a longer-dated futures contract. When the futures curve is in backwardation, this return is positive, but if the futures curve is in positive spread, this return is negative; if the futures curve accurately predicts future prices, investors will not generate any profit or loss.

Mortgage remuneration: futures contracts do not require investors to pay the full contract value in advance (only a small part, called margin (margin)). Investors can choose to invest the remainder of the contract value in another alternative instrument (usually Treasury bills, but sometimes cash) for the life of the contract. Staking returns are returns from other investment vehicles. For example, when you choose to invest US$1,000 in crude oil futures, you may only need to pay a 10% margin, that is, pay US$100 in advance to obtain the right to purchase crude oil in the future. At this point, you can choose to invest the remaining $900 in interest-bearing Treasury bills and earn a little extra profit, which is tantamount to ensuring that you will have enough funds to pay for your futures investment.

Forward contracts are similar to futures contracts in that they are agreements on the future prices of raw materials and commodities. However, since the forward contract is not a standardized contract, the transaction is usually not carried out on the exchange, and it is subject to relatively little supervision. Therefore, the transaction cost may be higher, because it is a customized product between the buyer and the seller, and usually involves physical delivery. Since there is no clearing house for forward contracts, there is a risk of default.

There is also an option market for raw material commodities, which operates in a similar way to other option markets. The buyer pays a premium for the right to buy (call option) or sell (put option): buy a certain raw material commodity at a fixed price (strike price, strike price) on or before a certain date. Options can be traded on an exchange or over the counter. Exchange-traded options mostly involve the right to buy or sell raw commodity futures contracts, rather than physical assets.

Finally, raw material commodities can also be traded through exchange contracts (swap), which is a cash exchange based on the price of a specified raw material commodity. It is usually a way for consumers of raw material commodities to avoid sharp price fluctuations. The two parties agree on the price and time. If the actual price is significantly higher than the set price, the additional cost must be paid by the seller to the buyer who exchanges the contract; conversely, if the actual price is much lower than the set price, the buyer must pay the difference. Producers of raw commodity goods can use swap contracts in a similar way, allowing them to lock their products at a specific price.

Commodity futures and options on raw materials accounted for 21 percent of exchange volume in 2019, up from 13 percent in 2010, according to data provided by the World Federation of Exchanges. At the same time, the number of contracts traded rose from 2.5 billion to 6.9 billion.

◎Investing in raw materials is much easier than before

Even now, it is still difficult to invest in the spot market of raw materials, but investors may not pay too much attention to this issue. Except for gold, it is difficult for ordinary people to make money through the spot price, because when buying the spot price of raw materials, they must pay for storage and transportation costs. Also, the opportunity cost of storing raw goods increases with interest rates because raw goods don’t generate interest for you. Therefore, compared with other financial assets, raw material commodity spot is not so attractive. If investors want to invest in exposure to raw material commodities anyway, there are many alternative methods available, but these methods are mainly related to raw material commodity futures.

The primary factor that has catalyzed many changes in the raw material commodity market in recent years is the development of the raw material commodity index. These indexes usually fluctuate with the price of a basket of raw commodity futures, but the compilation methods of different indexes are quite different. We can distinguish these indexes by the breadth of the index coverage (the number of raw material commodities), the weight of different raw material commodities in the index, and the “rolling mechanism” of the index (referring to the way the futures contract is rolled after it expires). Most indexes will roll over their positions every month, but some investment banks have also launched an enhanced version of the index, the purpose is to invest in different contracts on the futures curve (including futures that expire in the near future or in the future), so that Optimize the rollover mechanism.

There are many raw material commodity indices, some of which are not designed for investment purposes, such as:

United Nations World Food and Agriculture Organization (FAO) Food Price Index (FAO Food Price Index)

World Bank commodity price indices

IMF commodity price indices

Central Research Bureau commodity price indices

The Economist commodity price indices

The benchmark price indexes of raw materials and commodities used as investment reference include:

S&P GSCI (Standard & Poor’s and Goldman Sachs Commodity Index)

Bloomberg Commodity Index (Bloomberg Commodity Index, formerly known as Dow Jones UBS Raw Materials Commodity Index DJ-UBS [Dow Jones-UBS Commodity Index])

Rogers International Commodity Index

However, these companies do not have an overall benchmark index. Each index is developed for a specific block in the raw material commodity market. The main purpose is to allow investors to have a reference when allocating funds for a specific raw material commodity or a certain sub-category of raw material commodity. Benchmarks such as the S&P GSCI industrial metals index. Another deformation index evolved from the traditional raw material commodity index may be related to the rollover time point or rollover method of the futures contract. enhanced index).

The raw material commodity index is an effective channel to intervene in the raw material commodity market, however, index investment is a passive investment. In other words, this kind of investment is not the culprit that triggered the bubble in the price of raw material assets. Index investors do not hoard a large amount of raw material commodities and wait to sell them at a higher price in the future. Therefore, such investors will not cause a change in the demand side of a certain raw material commodity. The proportion of funds allocated to specific raw material commodities through this passive investment target is relatively stable, and its allocation is not affected by the shape of the futures curve.

Since it is not easy for retail investors to trade in the raw material commodity futures market, many investment tools that help them intervene in this market have emerged as the times require. Most of these tools exist in the form of exchange-traded products (ETP), especially exchange-traded funds (ETF) or exchange-traded notes (ETN). ). An ETF can invest in a raw material commodity index, a specific raw material commodity, or a basket of raw material commodities. In recent years, the purpose of ordinary people investing in index products is mostly to obtain exposure positions of precious metals and agricultural raw materials commodities, rather than base metals.

An ETF is simply a fund that holds a specific portfolio of underlying assets. Shares in ETFs are traded on stock exchanges like ordinary business shares. In the past, the ETFs of the raw material commodity index were passive investment targets, and they established the fund’s holding position completely according to the index components; however, in recent years, more actively managed ETFs have been launched one after another. Because it is an active investment target, managers of such funds will try to increase the rate of return from the index. Some ETFs are physically backed, meaning that the manager of the ETF holds the underlying physical raw material commodity. This is especially common in gold ETFs because it is easy to store. However, most physical ETFs for industrial raw material commodities have been criticized for reducing the availability of raw material commodities to industrial end customers.

ETN is a kind of bill or bond, and investors can buy this commodity through financial institutions. The bond’s return is linked to the return of the underlying asset, such as a raw material commodity index. The risk of ETN is higher than that of ETF, because it also involves the risk of financial institutions themselves. After all, financial institutions may still be unable to repay the bond principal.

◎Why invest in raw materials

Since 2000, despite the sharp fluctuations in commodity prices, related investment activities have flourished. According to the textbook, the main benefit of investing in raw material commodities is to diversify the risk of the investment portfolio. At the same time, raw material commodities are also a good tool to avoid inflation risks. For example, raw commodity prices usually rise due to natural disasters (such as drought) or geopolitical tensions, while other assets such as stocks usually fall in value during these scenarios.

Certain other investors may believe that raw material prices will rise based on short-term economic prospects in large commodity consuming countries such as China or the United States, or on general economic factors such as peak oil (see previous chapter).

There are other more pragmatic reasons for the increase in investment in raw material commodities in recent years, including lower transaction costs and more and more financial raw material commodities to choose from (although the industry also responds to investors’ eagerness to intervene in the raw material commodity market. roll out).

◎Diversified investment portfolio risk

It is generally believed that asset managers can hedge against overall economic risks or the risks of market events that may have a similar impact on most other financial assets (especially stocks) by holding raw material commodity assets. Between 1971 and 2007, the Standard & Poor’s 500 (S&P 500) stock market index had negative returns in eight years, but the raw materials commodity market had positive returns in six of those eight years . However, the boom in investment in raw materials commodities, which was particularly strong around 2000, has eroded the benefits of portfolio diversification. Raw commodity markets are now more susceptible to investor portfolio rebalancing than before, which in turn increases the correlation between raw commodity markets and other financial asset markets, including stocks.

In addition, in recent years, the trading pattern of the raw commodity market has been very similar to that of other financial markets, especially the stock market. Commodity markets, like stocks, rallied when the outlook for global economic growth looked imminently improving, or when authorities adopted loose monetary policy to boost growth. This may be a temporary phenomenon in the current ultra-low interest rate environment. As monetary policy begins to tighten, the original characteristics of raw materials that help diversify investment portfolio risks may gradually recover. There is a theory that raw commodity markets will be positively correlated with stocks when prices are driven by demand trends (such as strong demand driving prices up); , the fluctuation of commodity prices of raw materials will be different from that of stocks. Another theory is that we are past the financialization of raw commodity markets and that the benefits of risk diversification will return in the coming years. This is based on the fact that investors are holding far less raw commodities than they did in the first decade of this century. However, this theory is less tenable when you consider that investors are likely to return in large numbers after commodity market conditions improve.

◎Use raw materials to avoid inflation risk

Raw commodity prices may also move higher if inflation picks up gradually. In fact, the price of raw materials and commodities is likely to be the cause of the increase in the inflation rate. However, when the inflation rate rises, the stock market usually falls, mostly because the central bank may adopt tightening monetary policy at this time to suppress inflation, resulting in lower economic growth rate.

Some investors do not invest in raw material commodities at all based on some seemingly good reasons. Their reason is that the trading volume of the raw material commodity market is too thin, so it is easy to be manipulated. Although this risk no longer exists, price fluctuations are still very violent.

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