Monday, August 20, 2007

Small Investors Shut Out Of Commodities

WhiteMan brought up the salient point that the fees were too high for indexed commodity funds. He's right. Here I will illustrate why they can charge so much. Quite frankly, commodity contracts are too big for a small investor to buy a basket thereof.

Just consider the four I bought last week. One mere contract of each represents the following dollar investments:

Sugar - $10,500
Cocoa - $17,800
Cotton - $28,500
Coffee - $44,500

Add them up and you get a $100,000 investment. How much money does one have to have to justify gambling 100k?

Well, I don't think most investors should have more than 20% of their assets tied up in commodities. That implies that in order to have enough dough, just to buy the four I bought last week, an investor should probably be working with a 500k portfolio.

Here come the qualifications:

Unlike options and equities, coffee and cotton CANNOT go to zero. Gold and oil will always retain value. Therefore, on that level, it's somewhat less risky to buy them than other financial assets.

BUT, they do have carrying costs and do compete with technological breakthroughs. For example, cotton competes with low cost man-made fibers like rayon. Even diamonds have technically lost value with the development of moissanite (see CTHR).

I don't even want to talk about margin as it can be as low as 5%-10% for some commodities - so one could theoretically buy this $100,000 basket for under ten grand. BUT with such a low investment, obviously a 10% dip would wipe you out. This is the lesson of today's housing debacle - one's purchases should be based solely on your long-term financial means NOT what some dopes are willing to lend you.

Commodities are volatile instruments. Just in the one week that I purchased my little basket, here is their performance:

Sugar - down 4.1%
Cotton - down 4.6%
Cocoa - down 5.9%
Coffee - down 4.3%

So again, forget about margin and focus on total dollar risk.

Bear in mind that the minimum basket of my example only has four basic commodities in it. A true broad-based commodity basket needs oil, precious metals, lean hogs, soybeans, wheat, corn, oats,...

This is why "commodity pools" exist. Small (and big) investors need to pool their monies to sit at this high stakes table.

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