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Are commodities investments a net zero game?
Old 03-16-2007, 11:41 AM   #1
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Are commodities investments a net zero game?

When we make an equity investment, we are expecting to capture some of the value that the company creates by utilizing its assets in the market place. At the end of the day, this number is captured in GDP growth, which I believe is pretty close to the long term excess return on stocks. This makes sense, because the companies are worth more than the sum of their parts over time, and this value accrues to the investors.

However, commodities are an investment in a physical item - while the price may change based on supply and demand and expectations, a barrel of oil doesn't create any new value (unlike a company, which does). Therefore, does it make sense to invest in a commodities fund (such as PCRDX/PCRIX or DJP) over the long term? You may take some profits along the way, but these profits are not due to true economic value creation, just fluctuations in prices.

I am wondering if commodities are more like the currency markets, where individual traders can make speculative profits but the total system is a zero sum game. Contrast this to the equity markets, which is not a zero sum game.

If an investor is looking for inflation protection, maybe it's better to stick with TIPS or other inflation-linked bonds?
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Re: Are commodities investments a net zero game?
Old 03-16-2007, 11:46 AM   #2
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Re: Are commodities investments a net zero game?

That's up to you to decide. But I will note that there are large players in the commodity futures markets who are loking to lay off risk even though they know it will cost them money. That is a source of return for people willing to take the other side of the trade.
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Re: Are commodities investments a net zero game?
Old 03-16-2007, 11:48 AM   #3
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Re: Are commodities investments a net zero game?

To make a long story short, it's all in the rebalancing.
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Re: Are commodities investments a net zero game?
Old 03-16-2007, 12:59 PM   #4
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Re: Are commodities investments a net zero game?

zero sum, minus the commissions and spread
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Re: Are commodities investments a net zero game?
Old 03-16-2007, 01:02 PM   #5
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Re: Are commodities investments a net zero game?

I'm not an expert, but lookup "normal backwardation." Investors can make money from hedgers. Too sophisticated for me.
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Re: Are commodities investments a net zero game?
Old 03-16-2007, 01:19 PM   #6
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Re: Are commodities investments a net zero game?

While I agree that a traditional speculative futures position is a "zero-sum" game, I disagree with the assessment of DJP and PCRIX. They make money in three different ways:

1. By investing the underlying capital in risk-free Treasuries. The base return should be at least 4.5%, minus the cost of implementing futures contracts.

2. Exploiting the difference between a futures price and the current spot price. See the "normal backwardation" point mentioned by wab.

3. Inflation in the commodity price due to a net long position.

In practice, buying DJP today can generate 8-12% returns over the long term. How?

1. 4% from Treasuries minus the cost of acquiring futures contracts.
2. 2-4% from exploiting structural mispricings and taking advantage of the "carry trade".
3. 2-4% inflation.

Compare to the GLD fund where you only realize returns from source #3 over a very long time horizon....

- M
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Re: Are commodities investments a net zero game?
Old 03-16-2007, 01:44 PM   #7
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Re: Are commodities investments a net zero game?

Very interesting, I was not familiar with "backwardation". There is an interesting article from Bernstein here:

http://www.efficientfrontier.com/ef/0adhoc/stuff.htm

Where he argues that investors could profit from backwardation in the past when those who were selling the risk of price deflation were happy to get it off their hands, but now there are many who want to sell the risk of price inflation instead, and they are now charging a premium for that.

I agree that profit can be earned in exchange for taking risk of someone else's hands (in this case, the producers of the commodities) but you haven't really created any new value, you're just shifting risk. So then the ability to earn excess returns depends on your ability to price risk better than the person sitting on the other side of the transaction.
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Re: Are commodities investments a net zero game?
Old 03-16-2007, 01:48 PM   #8
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Re: Are commodities investments a net zero game?

Quote:
Originally Posted by soupcxan
Very interesting, I was not familiar with "backwardation". There is an interesting article from Bernstein here:

http://www.efficientfrontier.com/ef/0adhoc/stuff.htm

Where he argues that investors could profit from backwardation in the past when those who were selling the risk of price deflation were happy to get it off their hands, but now there are many who want to sell the risk of price inflation instead, and they are now charging a premium for that.
Agree. The idea that commodity hedgers and active investors will regularly serve up positive returns for passive riders is too naive to even consider.

Has anyone looked for "normal backwardation" lately? Not much to be found is there?

Ha
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Re: Are commodities investments a net zero game?
Old 03-16-2007, 02:21 PM   #9
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Re: Are commodities investments a net zero game?

I have wondered myself if commodities themselves are another asset class, or simply investing in an emerging market fund gives you the same aspect of diversification. I remember reading somewhere that they are very closely correlated, since most commodities are mined/processed from emerging countries.

I wonder if both are really necessary, or one is enough. If I were to pick one, I'd stick with emerging markets as it is much easier for a layman to understand the equity markets (and their generally upward bias), as opposed to the futures markets.

Disclaimer- I own both an emerging markets fund as well as DJP, 5% of each.
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Re: Are commodities investments a net zero game?
Old 03-16-2007, 04:30 PM   #10
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Re: Are commodities investments a net zero game?

They're not a net zero game if you're holding a barrel of oil or a bushel of wheat.
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Re: Are commodities investments a net zero game?
Old 03-16-2007, 05:42 PM   #11
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Re: Are commodities investments a net zero game?

Quote:
Originally Posted by soupcxan
Very interesting, I was not familiar with "backwardation". There is an interesting article from Bernstein here:

http://www.efficientfrontier.com/ef/0adhoc/stuff.htm


I agree that profit can be earned in exchange for taking risk of someone else's hands (in this case, the producers of the commodities) ....
Well, that was interesting, but something does not ring true for me...

OK, so wheat is trading @ $2.00. Supply meets demand, and every bushel of wheat produced is purchased @ 2.00. The supply side sellers want protection against prices below $2.00, and demand side buyers want protection from prices above $2.00. It would seem they could trade risk between themselves - they don't need to go outside looking for a market for their risk. Just contract to trade ata future date for $2.00 plus the time value of risk-free money, plus the cost of storage of the wheat. Seems that speculators are not required.

I would think that a commodities futures market could simply be a meeting place to bring these two buyers/sellers together.

Ahhh, that is pretty much what wiki says:
Quote:
When the deliverable asset exists in plentiful supply, or may be freely created, then the price of a future is determined via arbitrage arguments. The forward price represents the expected future value of the underlying discounted at the risk free rate—as any deviation from the theoretical price will afford investors a riskless profit opportunity and should be arbitraged away; see rational pricing of futures.

....

This relationship may be modified for storage costs, dividends, dividend yields, and convenience yields.

-ERD50
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Re: Are commodities investments a net zero game?
Old 03-16-2007, 06:56 PM   #12
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Re: Are commodities investments a net zero game?

Wise Advice: If you do not understand it do not invest in it.
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Re: Are commodities investments a net zero game?
Old 03-16-2007, 07:06 PM   #13
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Re: Are commodities investments a net zero game?

Not a zero sum game.... because you buying that commodity means that the 'demand' is going up... someone will try and prduce more of that 'product', be it corn, wheat or pig bellies...

And as someone said... if you owned that oil.. and tomorrow someone said they have perfected cold fusion and could produce all the electricity you wanted from water... well, you can keep you oil...
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Re: Are commodities investments a net zero game?
Old 03-16-2007, 08:12 PM   #14
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Re: Are commodities investments a net zero game?

Another interesting thought is how commodities compare with real estate ... and how commodities differ from each other.

A bushel of wheat differs from a barrel of oil, especially if you're a "peak oil" fan ...


Personally, I think long positions in some commodities can be helpful for a small portion of the portfolio ... and, sh*t happens, causing some commodities to get interesting. These days, we can look at the historical peformance of long positions in a few different commodity classes, and some are quite respectable.
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Re: Are commodities investments a net zero game?
Old 03-16-2007, 08:42 PM   #15
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Re: Are commodities investments a net zero game?

I don't really see how real estate and commodities are comparable...RE is used for a variety of things but it's usually still standing when you're done with it - and it produces cash flows over time. Not so a barrel of oil or a bushel of wheat - once it's burnt/eaten, it's gone.
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Re: Are commodities investments a net zero game?
Old 03-16-2007, 09:21 PM   #16
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Re: Are commodities investments a net zero game?

Generally, gold isn't gone ...

And, improved real estate is eventually obsolete.

Hardly the same, but I do see those asset classes as having some characteristics in common.
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Re: Are commodities investments a net zero game?
Old 03-17-2007, 07:17 AM   #17
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Re: Are commodities investments a net zero game?

I think we need to decide whether we are talking about commodities futures, or physicals because people are arguing both here and they are different animals


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Re: Are commodities investments a net zero game?
Old 03-17-2007, 12:34 PM   #18
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Re: Are commodities investments a net zero game?

Quote:
Originally Posted by saluki9
I think we need to decide whether we are talking about commodities futures, or physicals because people are arguing both here and they are different animals
Exactly; commodity futures are necesarily a zero sum game. Negative game to all participants taken as a whole, since they have to cover the costs of the game. A lot of people take offsetting positions, put up some money, and if Bill loses $5000 on his long Dec Corn contract, Jenny makes $5000 on her short contract- less the leakage to costs.

Just like betting on a horse race

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Re: Are commodities investments a net zero game?
Old 03-18-2007, 09:12 AM   #19
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Re: Are commodities investments a net zero game?

Quote:
Originally Posted by milmoose
While I agree that a traditional speculative futures position is a "zero-sum" game, I disagree with the assessment of DJP and PCRIX. They make money in three different ways:

1. By investing the underlying capital in risk-free Treasuries. The base return should be at least 4.5%, minus the cost of implementing futures contracts.

2. Exploiting the difference between a futures price and the current spot price. See the "normal backwardation" point mentioned by wab.

3. Inflation in the commodity price due to a net long position.
"Normal backwardation" is only "normal" absent financial players because it presents a risk free arbitrage opportunity. Historically this may have been a "normal" situation but with the emergence of hedge funds and everyday investors with access to commodity investment vehicles the idea that backwardation will be the normal state of the market going forwards seems preposterous. It may even be true that the inflow of "dumb", long-only, retail money into commodities, without the sophistication to analyze what they are buying, could push the balance decidedly against the longs.

The "normal" state of the market is contango where future prices are set by the cost of carry, storage, and expectations regarding the future price of the "underlying" commodity. So to break down your 3 sources of return:

1) "Funding" a long-futures contract by investing in treasuries does not produce excess return, it only compensates for the cost of carry embedded in the contract. The idea is that a futures contract + a treasury actually creates a synthetic position in the underlying, not the underlying + interest. You don't get something for nothing in finance.

2) As mentioned earlier, "normal backwardation" is not normal. You can overcome the financial cost of carry by "funding" the futures contract. You should, however, lose whatever value is embedded for storage costs.

3) Inflation / changes in supply and demand are your true source of return for owning commodities. But like all investments, expectations play an important role. When you buy a futures contract, you are buying today what the market assesses the value of the underlying will be at T + 1 (plus financing and the cost of storage). It seems you only make money doing this when the market underestimates what the future price will be, and lose when the reverse is true.

To the extent the market is reasonably efficient (or even just balanced in the error of its future price outlook) buying and holding commodity futures contracts seems like a zero sum game to me.

Less, of course, the ~1.2% that PIMCO takes.
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