Commodities: Risks as High as an Elephant’s Eye
Sharp price hikes for many agricultural and industrial commodities, and forecasts for even more gains ahead, have spurred renewed interest in the highly volatile and intensely risky “futures” market, where fortunes are made and lost in the blink of an eye.
Interest in the raw-materials side of the commodities markets was fairly moribund all through the 1980s and into the early 1990s, as investors focused on more sophisticated financial products such as stocks, bonds and interest rate contracts, experts note.
But thanks partly to soaring values for items such as coffee, cocoa, lumber, cotton and copper, sophisticated investors are returning to “traditional” commodities and are promising a revival in this long-maligned industry.
“We have seen more interest in the commodity sector from sophisticated investors recently than we have seen in a long time,” says Hunt Taylor, managing director of Reynwood Trading Corp. in Short Hills, N.J.
However, analysts readily acknowledge that the bulk of investors in this highly volatile market lose money rather than make it. Even when the market holds the potential for stunning double-digit returns, investors must be cautious, they say.
How do you make a killing without getting killed?
Realize, first, that there are essentially three ways to invest in commodities.
You can invest on your own by setting up a commodity trading account with your friendly neighborhood broker. The broker would then open a margin account for you that would allow you to borrow a portion of the cost of each commodity contract from the brokerage. In other words, if you wanted to buy a $100,000 contract on wheat futures, the broker might require only a $5,000 deposit. The remaining $95,000 purchase price would be borrowed from the brokerage firm.
As long as your contract rises in price--or stays level--the $5,000 is your entire cash investment. But if the value of the contract falls, you’d be subject to a “margin call,” for which the broker requires you to kick in more cash to secure your loan.
You can also choose to trade through a commodity trading adviser. CTAs, like other money managers, agree to invest your money for a set fee. In the commodities market, the fee usually works out to about 3% of your assets, plus 15% to 25% of any profits the adviser earns for you. Most CTAs require minimum investments of $10,000 or more. Some won’t take accounts of less than $1 million.
Because of the huge investment requirements with CTAs and the chance of losing more than your initial investment when you open an individual commodities account, the bulk of middle-income investors are advised to enter this market through commodity pools. Commodity pools are the futures industry’s answer to a mutual fund.
Operated by many major brokerage firms, such as Merrill Lynch and Dean Witter, commodity pools allow fairly modest investments of between $2,000 and $5,000. Like mutual funds, commodity pools are sold through prospectuses that detail many of the risks and rewards of the pool.
It is imperative that investors read these documents carefully, because not all commodity pools are alike. Some are fairly conservative, while others are highly risky. Some boast long and illustrious track records, while others are new and have little to show in the way of past performance.
What do you look for in the disclosure documents?
* Risks. Pools must detail the risks of commodities investments in general and of the pool in particular. Some of this is simply boilerplate, but it should prepare you for the general risks in the market.
* Background of the principals. The principals of the pool must disclose pertinent information about their employment history, conflicts of interest and any past criminal, administrative and civil actions taken against them.
* Investment methodology. Some pool investments are based on computerized models. Other pools follow technical trends or engage simply in discretionary trading. The pool will also disclose how its cash is divided among commodity trading advisers and what segments of the commodity market those advisers specialize in. If you want to invest in agricultural commodities, look for a pool that specializes.
If you want a diversified pool, make sure the operators are dividing the pool’s cash among a well-rounded group of CTAs.
* Redemptions. To limit the possibility of a cash crunch that will force the pool managers to sell positions at inopportune times, most funds limit your ability to cash out to just once a month or once a quarter. If you miss the redemption date, you must wait until the next one. If you have immediate needs for your cash, the redemption dates are pivotal.
* Fees. Brace yourself. Fees in this industry are stunning. The average commodity pool will charge between 7.5% and 10% of your invested capital each year . However, if the results are still good, fees in this range shouldn’t discourage you.
* Performance. The hardest thing about reading a pool disclosure statement is that there is so much performance information that it’s hard to discern what it all means.
Pools must disclose their month-by-month investment returns for their entire history or for three years, whichever is longer. If the pool doesn’t have much of an investment history, it must disclose the investment history of its principals. Any adviser who invests more than 10% of the pool’s assets will usually list his or her investment history as well.
The figures should all be net of fees. In other words, what’s reported is what investors earned after all fees and expenses were deducted. However, realize that when performance figures are listed for the CTAs rather than the pool, the pool’s fees are not included.
In other words, pool investment results are more telling than CTA investment results.
Also be wary of hypothetical return information. Some pools “back test” newly formulated trading strategies and then report how they would have fared if they’d used the strategy with real money. Hypothetical results always look great, but they mean nothing.
Finally, realize that past performance does not predict future returns. However, past volatility is a good indicator of future volatility, says Sol Waksman, president of Barclay Trading Group Ltd., a Fairfield, Iowa-based futures consulting and publishing company.
Waksman, who studies CTA returns, says many investors make the mistake of pouring their money into a pool immediately after it’s had a great month. But they don’t notice that monthly returns gyrate wildly. Then, when the inevitable happens and the fund has a losing month, they get frightened and bail out.
Jumping in and out of commodities is a great way to lose a lot of money quickly.
Investors should carefully note how much the fund’s results vary and determine whether they’re comfortable living with the swings. If you’re not, invest elsewhere.
