Know what you own

21May06

A piece in this week's Barron's by Spencer Jakab reminded us of one of prior posts on the topic of passive investments in commodities. If you are invested (or thinking of investing) in a indexed commodites vehicle this article is a good one in that it helps explain the source of those returns.

Unlike prior commodity price booms this one is seemingly being driven by an influx of capital seeking out passive, indexed, commodity exposure. The upshot is that this capital influx may very well be undermining the fundamental case for commodity diversification via the futures market. In this post we discussed the academic study underlying much of the excitement over the "nirvana-like" properties of commodities.

In his article Jakab covers three important points.

  1. A huge sum of money has entered the commodities market;
  2. The basis of the theory behind this move requires commodities market be "backwardated" most of the time. Currently many major markets are in "contango."
  3. Some analysts believe this influx of capital has changed the equation in the futures market thereby negating a major source of returns for fully collateralized commodity futures.

This article should serve as a wake-up call. Early adopters of the thesis behind passive commodity investing benefited from a bull market in the spot price of nearly every commodity. However the basis underlying this thesis may very well have changed.

It is incumbent on informed investors that they know in what they invested. If terms like "contango" and "backwardation" are not in your lexicon then it is advisable that you learn them sooner rather than later.

You can find an article explaining the concept behind commodity futures pricing here, and you can read more of our commodities coverage here.

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