How to Invest in Commodities

Commodities have become so overheated, it seems investors will go anywhere and risk anything to try to take advantage of the monster moves.

 

Recently, we saw another small commodity fund, Peak Ridge Capital, go bust and get sued for $40 million dollars by Morgan Stanley(MS_), its broker and clearing dealer.

What's interesting about Peak Ridge is that it's connected, at least marginally, to a great rogue of commodity trading, Brian Hunter.

The same Brian Hunter sank the enormous Amaranth fund in 2006 with natural gas trades that cost the fund almost $7 billion dollars. This was by far the largest blowup of an independent commodity fund on record.

From Amaranth, Hunter managed to raise capital to try again at his own fund, Solengo advisors, which went bust as well. Its assets were bought by -- that's right -- Peak Ridge.

It was in natural gas trades that Peak Ridge got caught and was unable to meet margin calls -- trades that Peak Ridge "adviser" Brian Hunter specializes in.

I outlined Hunter's history today on CNBC's "The Call" with Melissa Francis.

The obvious question from this latest fund blowup is: Why do investors continue to throw money at dangerous funds run by risky traders?

The next question is: If the desire to be engaged in super-hot commodity funds can overcome all reason, what is the proper way (if any) to try and gain access to the big run in commodities?

There are three ways to directly gain access to commodity prices for retail investors, and each has positive and negative aspects.

The first is commodity index funds. These have the most direct correlation to commodity prices and track baskets of commodities using futures markets and over-the-counter contracts (swaps) to try and correctly mirror the motion of all commodities. PIMCO's Commodity Real Return Strategy fund is an example of one of the biggest of these.

The biggest problem for retail investors is the high minimum investments most index funds have. They are largely created and run for huge institutional portfolios, pension portfolios and high-net-worth investors. Many have a $100,000 minimum or more.

For investors for whom the high cost of admission of index funds is daunting, there is the option of commodity exchange-traded funds. They include full-basket ETFs such as theiShares GSCI ETF(GSG_), the iPath DJ-UBS commodity ETN(DJP_) as well as commodity-specific ETFs such as United States Oil(USO_) and the United States Natural Gas(UNG_).

The final method for accessing commodity exposure is through managed futures funds -- like the doomed Peak Ridge and Amaranth funds. This is clearly the riskiest method for retail investors as you do not necessarily track the basket of commodity prices. You are, in fact, betting on a trader and his ability to outsmart a market, as with any other hedge fund. You do avoid the "roll premium" implied by most ETFs, but of course you also risk a possible "blow up" that wipes away all of your investment.These funds offer immediate and easy access for retail investors, as they are traded and priced just like stocks. They are, however, uniformly horrible investments. The fund fees tend to be high. What's more, these funds are forced to use front-month commodity futures to correlate the fund's price to commodity prices. They're also forced to "roll" their futures positions every 30 days, a profit-robbing contrivance for shareholders. At best, commodity ETFs represent value for a just few days and are best used as a daytrading tool. Any long-term investment in these ETFs will vastly underperform the commodity basket's movement, whether up or down.

So what is the takeaway? If all three direct investment vehicles have unique handicaps, how should you invest?

My advice is to commit to stocks that are directly correlated to commodities. In commodities such as gold and copper you can invest in mining stocks, and in oil and natural gas you can invest in energy producers.

Unfortunately, there's no way to gain access to many of the soft commodities such as corn and coffee using this method.

Of course, the human element of greed will ensure that we continue to see commodity funds raising easy capital from investors looking to capture some outsized gains, and we'll continue to see some of them explode, taking all the investor money with them. That's how inviting this overheated commodity market looks right now.