INVESTING IN COMMODITIES PART 2

Commodity investment options


An important aspect we need to cover is which instrument or investment vehicle you will use to participate in this commodity bull market. For those readers domiciled in the United Kingdom, I suggest you consider establishing all your investment positions as spread bets.
Tax-free investing
Spread betting offers the exciting opportunity to participate in and profit from this investment boom without having to pay any capital gains tax (applicable to UK residents - investors from other countries need to conduct their own due diligence). Yes, if you establish and maintain your commodity investments via spread betting, all your profits will be tax free and, not only that, this type of investing is regulated by the Financial Services Authority (the UK financial services regulator).
Spread betting in the UK has been around for over 20 years. Initially aimed at and used by dealers in the City of London, spread betting is now growing in popularity throughout the country. As I mentioned earlier, its main benefit is that, under current UK legislation (which could always change in the future), investment profits are not subject to capital gains tax. To illustrate just how powerful this tax-free status is to your investment returns, let’s look at the following example. We have two hypothetical investments of £50,000 each. Both investments are identical in every way except investment A pays a capital gains tax of 40 per cent on all annual profits whilst investment B is allowed to compound all annual profits as it doesn’t pay any tax. Assuming a 10-year performance where each year saw both investments gross a 10 per cent annual return, investment A would have grown to £89,542 (a gain of 79 per cent) whilst investment B would have grown to £129,687 (a gain of 159 per cent). Where else can you double the performance of an investment without any additional risk?
Another advantage to spread betting is the ability to establish a
credit account. Subject to satisfying the spread-betting firm you have
the necessary money, using a credit account means you can hold a
spread-betting position whilst still retaining your investment cash
in an interest-bearing bank or building society account. Should the
commodity investment prove immediately profitable, you could
find yourself in the comfortable position of earning interest on your
investment cash whilst also building up profits from the commodity
markets. However, if your market position begins to show a loss, you
will be required to cover the deficit with a transfer of cash to the credit
account.

How spread betting works
Spread betting has a wide range of applications suitable for a broad
spectrum of investors, enabling them to ‘bet’ on the price movements
of numerous shares, stock indices, bonds, currencies and commodity
futures. Typically, the larger spread-betting firms will quote on all the
major markets 24 hours a day between Sunday night and the close of
business in the United States on a Friday night. When you make a spread
bet, you never actually own the stock, bond or commodity. Instead you
‘buy’ the spread-betting broker ’s quote when you bet that a market
will rise. If the market subsequently goes up as you predicted, your
winnings multiply. Conversely, if the market moves in the opposite
direction to your prediction, then your losses will multiply. Similarly
to using futures, it is also possible with spread betting to control a large
amount of money with a small cash deposit and, whilst this leverage
sounds exciting, I want firmly to dissuade any novice from investing in
this fashion. A spread is a quote made up of two prices, which straddle the underlying market price. The higher ‘offer ’ price is for buyers and the lower ‘bid’ price is for sellers. Let’s look at an example of investing in silver. The commodity has a futures contract and the price quoted by the spread-betting broker will be based upon the market price of this futures contract. It’s July, and your strategy indicates that you should invest in this commodity. You call your spread-betting broker for a price of the September contract (the nearest and most active futures contract is usually known as the ‘front month’) and the quote is 725-729. You buy £10 a point at 729. This is the equivalent of approximately a £7,300 investment in silver (£10 multiplied by the spread-bet purchase price of 729 = £7,290). Let’s suppose your position turns out to be correct and a few weeks later your strategy instructs you to close your position for a profit. The spread-betting broker is now quoting 838-842 for the September contract and you close your position by selling the spread £10 a point at 838. You have now made a profit of 838 − 729 = 109 points. At £10 a point this represents a £1,090 profit (109 × £10), and a 15 per cent gain in the value of the commodity has produced a tax-free return of around 15 per cent on your £7,300 original investment.
If your strategy hasn’t provided an exit signal and the futures contract in which you hold your position reaches its expiry, you will have to ‘roll over ’ your position as this ‘front month’ contract matures. ‘Roll-over ’ is simply market terminology for moving your position from one contract to another. This is not as complicated as it sounds, because the spread-betting broker usually advises by letter when a contract is approaching its expiry date. When they write, they will ask if you wish to close the position upon expiry or ‘roll’ the position to the next contract. Unless you wish to close or readjust the size of your position, all you need to do is call them and confirm that you wish the position to be ‘rolled over ’. Typically, for this type of instruction, the spread-betting firm charges only a minimal spread (fee). It’s important to be aware that, as this commodity boom could run for many years, you may need to keep rolling your spread-betting position forward as each futures contract expires until such time as you ‘cash in your chips’ and close your investment. To close a position, simply sell whichever contract month your position is currently held in.
If you ever need help in identifying the current front month or in calculating the size of your spread bet relative to your financial commitment, the broker will always be able to help, and you should never feel uncomfortable about asking even the most basic of questions. It’s better to be safe than sorry.

Getting started in spread betting
To begin spread betting, you first need to open an account with a
regulated spread-betting broker. The Financial Services Authority
(details in Appendix A) will be able to provide a list of all the regulated
spread-betting firms. You should contact a number of these to obtain
the most competitive bid-offer spread rates, and once you have found
a suitable candidate you are ready to open an account. Typically, a
spread-betting account involves the extension of credit to the client via
a review of their personal finances and proof of liquid assets (cash). All
this is normally covered in the formal account-opening documentation,
but this can take a couple of weeks to process, so if you want to set
up your account more quickly you should consider opening a deposit
account instead. A deposit account is slightly different in that you are
required to ‘deposit’ cash with the spread-betting broker before you
can begin investing.
In addition, spread-betting brokers can provide you with detailed regulatory approved literature that further explains the mechanics and process of spread betting, and some even conduct free seminars to help new participants gain a greater understanding. If you are new to the business, I recommend you take full advantage of all the helpful information these brokers provide. After all, it’s in their interest to see you succeed, as the more money you make the more you will use them and the greater their commission revenue will become. Nobody benefits if a new customer loses money and then quits.

Another investment option the futures contract
As I’ve just reviewed, spread-betting brokers use an underlying futures contract on which to base their quotes, so for the benefit of those new to spread betting and for the non-UK-domiciled investors who gain no tax benefit from spread betting I want briefly to provide a little more information about the futures contract itself.
The idea of using futures is not new. This notion of fixing a price now
and settling later can be traced back to 2000 BC when the merchants of
Bahrain took goods on consignment for barter in India. A rudimentary
form of the risk-eliminating futures contract originated in England in
the 18th century, whereby two parties would agree in advance to the
terms of a sale, which was not finalized until the goods arrived. Such
contracts of sale on a ‘to arrive’ basis were made as early as 1780 in the
Liverpool cotton trade. Commodity exchanges originated in the latter
part of the 19th century as a means whereby merchants could rely on a
guaranteed price for goods they had to ship over great distances. In this
way, they could avoid the risk of price fluctuations eradicating their
profits during the long, slow shipment. The sale price was fixed at the
time of shipment and a deposit paid but the goods themselves were not
delivered until a future date, at which time the balance of the purchase
price became payable. In 1884, an organized futures market with rules
and regulations was founded in Chicago, Illinois. The Chicago Board
of Trade was to go on to fashion and operate the first futures contract
in a form that the English grain markets were to copy over 30 years
later. In the mid-1970s a revolution began to take place in the futures
markets with the introduction of financial futures. The main Chicago
exchanges, looking at the behaviour of some financial securities
such as shares and bonds, which were bought and sold around the
world, realized that many of them behaved in much the same way
as commodity markets. There appeared to be a need to provide the
financial world with an opportunity to hedge and speculate against
the underlying cash markets and so the financial futures contract
was born. Warning - futures contracts enable participants to leverage
their cash aggressively and it is for this reason that I caution you to
understand fully the subject of leverage, which was discussed earlier
in the book, before using them.

How futures contracts work
Basically, a futures contract is an agreement between two parties (a buyer and seller) for settlement of a specified security or commodity at a certain price on a given future date, as established on the floor of
an authorized futures exchange. It is a legal contract and in certain
cases can be fulfilled by the delivery and acceptance of the physical
commodity. However, the existence of clearing houses makes each
contract transferable and most futures contracts are closed out with an
offsetting futures transaction. To facilitate the clearing process, futures
contracts on the organized exchanges are standardized with regard
to the quantity and specific characteristics of the relevant underlying
commodity or financial security. In all cases, the relevant market
authority determines the minimum tradable quantity; the prescribed
minimum is called a ‘lot’ or ‘contract’. Lot sizes are published for
each futures market. The variables are the price, the delivery date, the
contract month and the identity of the buyer and seller. Most futures
contracts start one year before their maturity but some have lives as
long as three years or more.
A futures contract is quoted in two prices. The higher ‘offer ’ price is for buyers and the lower ‘bid’ price is for sellers. The process of using a futures contract to invest, including both ‘front month’ and ‘roll-over ’ procedures, is identical to spread betting, the only difference being that the bid and offer spread prices will be smaller. This is because you pay a commission to the futures broker whenever you trade, whereas the spread-betting firm include any costs in the spread itself, which makes their bid-offer price difference larger. In addition, because futures contracts have a fixed value with specified minimum price movements, they are slightly less flexible than spread betting.

Getting started in futures
To begin using futures contracts, you first need to open an account with a regulated futures broker. The Financial Services Authority (details in Appendix A) will be able to provide a list of all the regulated futures brokerage firms. You should contact a number of these to obtain the most competitive commission rates and, once you have found a suitable candidate, you are ready to open an account. Typically, a futures account operates in exactly the same way as a spread-betting deposit account where you are required to ‘deposit’ cash with the broker before you can begin investing. In addition, some futures brokers will provide you with detailed regulatory approved literature that further explains the mechanics and processes of using futures contracts. If you are new to the business, I recommend you take full advantage of all the helpful information these brokers provide. After all, it’s in their interest to see you succeed, as the more money you make the more you will use them and the greater their commission revenue will become. Just as with spread betting, nobody benefits if a new customer loses money and then quits.

Another investment option commodity-based funds

Although I rarely invest in mutual funds, there are a couple on the
radar offering general exposure to commodities. In addition, there
are numerous other funds available that primarily concentrate on the
energy and/or metals sectors. Those investors who wish to participate
in the boom but do not want to use spread betting or futures contracts
should consider using these funds as an alternative. I have included
these two funds for your information only and strongly recommend
you consult an independent financial adviser (IFA) to obtain recent and
past performance data and discuss fees, bid-offer spreads, minimum
subscription terms, redemption periods and other related items before
investing.
 Oppenheimer Real Asset Fund. This is an actively managed product
managed by a large and well-respected company. As with most
commodity proxies, it is heavily weighted towards the energy
sector with more than a 70 per cent exposure according to an article
in Forbes (June 2005).
 Pimco Commodity Real Return Fund. This product is the larger of
the two, based upon assets under management, and is designed
passively to track the performance of the Dow Jones-AIG Commod-
ity Index. It primarily achieves this goal through using futures
contracts based upon the DJ-AIGCI.
I’m sure as the commodity boom unfolds there will be plenty more commodity-based funds on offer as institutions attempt to cash in on the rally. The fact that there aren’t that many funds around at the
moment is further confirmation that this boom is still in its early stages
and when an exponential increase in the number of these products
does occur it will help us identify that the trend has entered its final
stage.

Another investment option - commodity stocks and shares
Another way to play this commodity boom is to identify and monitor listed companies whose business activity is primarily commodity based. Mining and oil exploration companies have been in the headlines recently and I’m sure there is plenty of potential for these and other similar stocks. My only reservation about investing in individual stocks and shares over and above the commodity markets themselves is that individual companies are susceptible to additional performance risks such as industrial action, taxation and general mismanagement.
Which investment option you decide to use is, of course, your decision. Personally, I direct all my long-term investing through the tax-efficient route of spread betting, but all of the options I’ve discussed here are viable ways to participate in a commodity bull market.