What Can Commodity Hedge Funds Trade?

Summary: Some of the most wide ranging, exciting and risky investments are in commodity hedge funds. This page looks at the reasons why and what an investor ought to understand.

When given a few minutes thought, the potential investment options for a commodity hedge fund are massive. For example:

- foodstuffs like wheat, soybean, maize, rice, coffee

- metals like gold, silver, copper, steel

- energy related like oil, gas, LPNG

- earths like uranium

And then of course, there are all the companies that specialise in individual commodities. There are major sugar, oil, paper manufacturers and many more. These are based around the world and are traded in different currencies and stock markets and even on different types of market (the Chicago Board of Trade for example).

On top of all the possibilities, there are currency issues to consider, macroeconomic policy (for commodities such as gold or oil), the weather (for crops) and geopolitical and democratic issues (much of the world's oil and gas deposits are in the Middle East and Africa, for example). This makes for fascinating, high risk, high potential reward, engrossing markets in which to compete.

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These factors also make it highly likely that an individual investor or trader probably should not be dabbling in these markets, with the exception of direct investment in the types of listed companies mentioned above. In actual fact, most of us have some form of exposure to the big oil and energy firms via our pension schemes.

Why should we not invest or trade in these types of asset?

Simply, because the markets can move in unexpected ways due to the latest market news or information that a private investor could never hope to keep up to date on. Most of us do not pretend to know in advance the impact of a speech on oil prices given by Hugo Chavez of Venezuela. But impact prices it may...

A great example of this happened in July 2015. The global economic backdrop included debt problems in Puerto Rico and the ongoing debt negotiations between Greece and it's eurozone partners. In such a climate, you might imagine that the price of gold would be firm as investors seek protection from borrowed money in the markets. Then in mid-July news of China selling some gold, China owning less gold than estimated and the potential US Fed interest rate hike, caused the price of gold to fall alarmingly. Virtually nobody predicted this. This had a knock-on effect on other metals (platinum, palladium, etc) and then onto mining companies. And it was so sudden...

There are also issues of scale. It is impossible to convince this author that a private individual really should be buying oil futures. Impossible.

Therefore, taking an interest in these markets via some form of investment fund does seem wise, or at least wiser.

The potential for extreme volatility in these markets does also seem to make them less than ideal for many forms of collective investment fund (mutual funds for example). These sorts of funds would usually stick to investing in oil and gas companies quoted on major stock exchanges, than buying actual oil or gas.

Thus, for more direct exposure to commodity markets, a commodities hedge fund might make sense. There will be times when selling a commodity short is the most sensible option and a mutual fund will not be in a position to do this. (We would argue whether an investor should want or need direct exposure to such markets in the first place).

Most commodity hedge funds are high risk places for investment. We would categorise them as the 'wild west' of hedge funds because of the places that need to be considered and the regimes and governments with which they may need to interact. In investment terms, this is not for widows and orphans.

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There have certainly been a number of commodity hedge funds that have blown up over the years. This has happened - and will continue to happen - when traders take large positions in a market (such as natural gas or corn) and the prices move against them in the short run. Too much borrowing on these contracts will mean that losses trigger margin calls and before very long, the fund have gone under.

It needs to be pointed out that past performance may well offer no guide whatsoever as to how commodity hedge funds may perform in the future. There are so many potential variables that exact systems may have little place in these markets. Of course, anyone that has managed to make an exact system work profitably in such an environment will not be sharing the details!

This means that there will be a certain amount of luck required in selecting such a fund.

A large percentage of such funds will be measured against a benchmark index such as the S&P GSCI. Formerly the Goldman Sachs Commodity Index, this index serves as the long-term guide to both commodity prices and economic health of the world economy. The index is heavy on energy but in reality this tends to reflect the impact of energy on the global economy.

If you would like to read more about hedge funds, please follow these links:

How Do You Define A Hedge Fund?

What Are The Best Hedge Funds?

How Do You Conduct Hedge Fund Due Diligence?

Is There Any Regulation Of Hedge Funds?

Why Invest In A Hedge Fund Of Funds?

What Do Forex Hedge Funds Do?

How Do Real Estate Hedge Funds Work?

How Risky Are Energy Hedge Funds?

How Can You Learn About Offshore Hedge Funds?