Home Wealth  Money The Case For Owning Commodity Futures

The Case For Owning Commodity Futures

Posted: Aug. 4th, 2010  |  By Forbes

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It's been a frustrating and volatile year for stock market investors. Just when we thought we were out of the woods after the financial market crisis, trouble in the eurozone reintroduced the possibility of a global double-dip recession. Both the Dow Jones Industrial Average and the Standard & Poor's 500 fell into the red this summer. U.S. Treasuries and cash may be safe, but where do you find return?

Gold has historically served as a safe haven in times of economic distress and has performed extraordinarily well over the past decade. Gold prices have risen for nine straight years, including a 24% gain in 2009. This May the metal reached a nominal record high north of $1,200 per ounce. All told. gold is up 8% so far this year.

Investors can access gold by buying coins or bullion, gold exchange-traded funds, like SPDR Gold Shares (nyse: GLD - news - people ) and iShares Comex Gold Trust (nyse: IAU - news - people ), or gold futures contracts. There are pros and cons to each, which include pricing, risk and taxes.

In Pictures: Seven Ways To Invest In Gold

While investors are familiar with gold, they may be missing an opportunity to participate in markets that offer similar diversification, including grains and energies. As with any asset class, investing in these commodities requires considering a number of issues and risk factors. Following are some of the most important ones.

Timing: In 1999, when the stock market was booming, commodities were a hard sell. Gold was trading below $300 an ounce. Crude oil was trading under $20 a barrel. Over the course of the following decade, gold rose 278% and crude oil 183%. Compare that with the "lost" decade for stocks.

One thing stocks and commodities have in common is that investors tend to buy them when they probably should be most cautious--when prices are near record highs. On the flipside, few investors were interested in buying crude oil contracts in 2009. Instead of going along with the crowd, however, ask yourself: What markets are over- or under-valued based on historical standards? And, how can I take advantage of that?

Pricing: When you buy or sell gold coins or jewelry, the price you pay or receive doesn't mirror the futures price due to the influence of retail demand and mark-ups. A coin or piece of jewelry is altered rather than a pure play on the commodity.

That's why many investors turn to ETFs or individual sector stocks to gain exposure to gold and other commodities, which are impractical to store and hold. Even when you invest in commodity-based stocks or ETFs, however, you aren't getting a perfect correlation to the price of the actual commodity. In fact, returns may vary significantly.

Investors who choose commodity futures get the purest play and are not subject to company-specific issues as they are when owning stocks or ETFs. Futures also enable investors to take positions on either side of the market and profit from a price decline as well as from a gain. If you feel the price of gold is going up, you can buy a gold futures contract (go long). If you feel it's going down, you can sell a contract (go short). Returns are not dependent on market direction, and unlike with ETFs and stocks, electronic futures markets are open nearly 24 hours a day.

Risk: The biggest risk with a stock or ETF is that it will become worthless and you'll lose your entire investment. Commodity futures, by contrast, are backed by tangible value that is unlikely to go to zero, but often they incorporate other risks. Often, investors buy them by putting down 10% or less of a full futures contract's value to hold a position. This is similar to using a down payment to buy a house. If you use leverage, both your gains and losses are magnified.

Success with futures involves a degree of skill, market knowledge and good timing. You need to be able to monitor your positions closely, and apply appropriate risk-controls. If you don't favor the do-it-yourself approach, work with a professional broker who can act as an advisor.

You can also access commodity futures though a managed account, which is even more hands-off. Managed accounts are akin to mutual funds; you pick the commodity fund or manager and he or she makes the trading decisions.

Taxes: ETFs are typically taxed like stocks, based on your holding period. That's fine if you are a buy-and-hold investor. If you're a more active trader, short-term capital gains can take a big hit out of your returns.

In the U.S., futures are lumped together and reported on a single Form 1099 at year-end. Profits, if any, are taxed regardless of the holding period at a 60/40 rate--60% at the favorable long-term capital gains rate and 40% at the short-term capital gains rate.

Gold coins or bullion can be taxed as "collectibles" subject to the 28% tax rate. ETFs backed by gold or silver can also be subject to this collectible rate. Higher rates and/or penalties may be applied if investments deemed "collectibles" are included in an independent retirement account or other self-directed retirement account. Consult with an accountant when making your investment choice.

Mark Sachs is president of Lind-Waldock, a Chicago-based futures brokerage division of MF Global.

Sources for commodity stats: YTD commodity performance via Finviz. Decade commodity performance via CNBC.




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