Due Diligence

7.1.Due diligence is needed

One way to minimize risk is to research all aspects of the investment you’re about to undertake — before you undertake it. Too often, investors won’t start doing research until after they invest in commodities contracts or companies A large number of investors buy on hype; they hear a certain commodity mentioned in the press, and they buy just because everyone else is buying. Buying on impulse is one of the most detrimental habits you can develop as an investor. Before you put your money in anything, you should find out as much as possible about this potential investment. The following sections go over the due diligence you should perform for each investment methodology:

1. Commodity companies– One way to get exposure to commodities is to invest in companies that process commodities. Although this is an indirect way to access raw materials, it is a good approach for investors who are comfortable in the equity environment. Here are a few questions you should ask before you buy the company’s stock: What are the company’s assets and liabilities? How effective is the management with the firm’s capital? Where will the firm generate future growth from? Where does the company actually generate its revenue from? Has the company run into any regulatory problems in the past? What is the company’s structure? How does the company compare with competitors? Does the company operate in regions of the world that are politically unstable? What’s the company’s performance across business cycles? Of course, these are only a few questions you should ask before making an equity investment. You can get the answers to these questions by looking through the company’s annual report and/or quarterly reports.

1. Managed funds– If you’re not a hands-on investor or simply don’t have the time to actively manage your portfolio, you may want to choose a manager to do the investing for you. You can choose from a number of different managers, including:

• Commodity Trading Advisor: Manager of individual futures accounts
• Commodity Pool Operator: Manager of group futures accounts
• Commodity Mutual Fund: Manager of mutual funds that invest in commodities

Before you invest with a manager, you need to find out as much as you can about him. Here are a few questions you should ask: What is the manager’s track record? What is her investing style? Is it conservative or aggressive and are you comfortable with it? Does he have any disciplinary actions against him? What do clients have to say about her? Is he registered with the appropriate regulatory bodies? What fees does she charge? How much assets does he have under management? What are her after-tax returns. Are there minimum time commitments? Are there penalties if you choose to withdraw your money early? Are there minimum investment requirements?

1. Futures market- The futures markets play an important role in the world of commodities. They provide liquidity and allow hedgers and speculators to establish benchmark prices for the world’s commodities. If you are interested in investing through commodity futures, you need to ask a lot of questions before you get started. Here are some of these questions: On what exchange is the futures contract traded? Is there an accompanying option contract for the commodity? Is the market for the contract liquid or illiquid? Who are the main market participants? What is the expiration date for the contract you’re interested in? What is the open interest for the commodity? Are there any margin requirements? If so, what are they?

1. Commodity Fundamentals- Whether you decide to invest through futures contracts, commodity companies, or managed funds, you need to gather as much information as possible about the underlying commodity itself. This is perhaps the most important piece of the commodities puzzle because the performance of any investment vehicle you choose depends on what the actual fundamental supply and demand story of the commodity is. Here are a few questions one should ask yourself before you start investing in a commodity, whether it’s coffee or copper. Which country/countries hold the largest reserves of the commodity? Is that country politically stable or is it vulnerable to turmoil? How much of the commodity is actually produced on a regular basis Which industries/countries are the largest consumers of the commodity? What are the primary uses of the commodity? Are there any alternatives to the commodity? If so, what are they and do they pose a significant risk to the production value of the target commodity? Are there any seasonal factors that affect the commodity? What is the correlation between the commodity and comparable commodities in the same category? What are the historical production and consumption cycles for the commodity?

7.2.Diversify

One of the best ways to manage risk is through diversification. This applies on a number of levels: both diversification among asset classes, such as bonds, stocks, and commodities and also diversification within an asset class, such as diversifying your commodity holdings among energy and metals. In order for diversification to have the desired effects on your portfolio, you want to have asset classes that perform differently. One of the benefits of using commodities to minimize your overall portfolio risk is that commodities tend to behave differently than stocks and bonds. For example, the performance of commodities and equities is remarkably different. This means that when stocks are not doing well, you will at least have your portfolio exposed to an asset class that is performing.