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Are You Investing In The Right Thing? A Common Misconception In Commodity Trading

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(Source: Luis Llerena)

Are you investing in the right thing, or can your opinions be expressed in more direct and simpler terms?

When investors, analysts, and prognosticators talk about their market views, they often reference the underlying "good" that is produced.

They tell you that if you are bullish on the outlook of handheld technology, you could express that in Apple. Have a view on electric cars? Perhaps Tesla could be of use. Think that you know where the stock market is headed directionally? An index ETF representing an overall stock market may make sense.

However, where this falters is when one has a view on a commodity.


There are countless examples of commodities rising or remaining stable while a stock falls.

The reality is that the performance of a commodity producing company is affected by many outside factors that could significantly impact their stock price. These include overall stock market correlation (beta), production costs, hedging policies and practices, organizational structure and competence, debt/equity financing, land positions -- the list goes on.

Yet, what affects the price of a commodity future or ETF? Only the commodity itself. Supply and demand in addition to technical elements of momentum and volatility play into this, but there are no other extraneous factors.

This all sounds great right? Well for the most part, it is.

The truth is, some commodities can be tough to directly invest in -- even for professional investors -- causing many to generalize about the inability to purely invest in commodities as a whole.

Seeing as there is no way to gain direct exposure to potash for example, if you have a view on fertilizer use and thus the underlying commodity, the next best thing may be an equity tied to the industry, like the Potash Corporation of Saskatchewan.

Similarly, if you have a view on the orange juice market because of cold or stormy weather in Florida, you could find a company that produces oranges or juice and invest in it. A more direct way to express this view does exist. Investors can make use of orange juice futures, however, many people do not have a futures account nor feel comfortable investing this way. Thus people will tend to turn to companies like Pepsico -- the owners of Tropicana -- even though this is not really all that ideal of an exposure given that the stock is subject to the performance of other product lines including food, soft drinks, water -- you name it.

The same could go for cocoa or sugar.

But not all commodities fall into this category.

Too often we hear views on the price of oil or natural gas expressed by taking a position in a corporation's stock that produces that commodity. We argue this is a very dirty way to express the opinion. There are simpler ways to directly express your view in energy commodities.

So what does this all mean?

If you have a view on the quality of a management team or the land holdings of an oil company coupled with a view on the direction of the stock market as a whole, invest in the company's equity.

If you have a view on a commodity, do your research and find an instrument to express that view directly and cleanly.

We recommend commodity-based ETFs, arguably the easiest and most effective way for investors to express a "pure play" opinion in commodities. If it is a view on oil or natural gas produced in Canada for instance, the largest foreign supplier to the United States, pick an ETF that exposes you to Canadian oil or gas -- not the market, not a company's long-term strategy, just the commodity and only the commodity.

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