Commodities and hedge funds offer unique investment opportunities beyond traditional stocks and bonds. These alternative assets can provide diversification benefits and potential returns, but come with distinct risks and complexities that investors must carefully consider.

Commodities are physical assets traded in global markets, while hedge funds use complex strategies to seek returns. Both require specialized knowledge and often involve higher fees and minimum investments than traditional options. Understanding their characteristics is crucial for effective portfolio management.

Commodity Investments: Characteristics and Types

Defining Characteristics of Commodities

• Commodities are physical assets such as agricultural products (corn, soybeans, wheat, coffee, sugar, cocoa), energy sources (crude oil, heating oil, natural gas, gasoline), and metals (gold, platinum, silver, aluminum, copper, lead, nickel, tin, zinc) that are interchangeable with other goods of the same type and primarily used as inputs in the production of other goods or services
• Commodities are often considered as a hedge against inflation because their prices usually rise when inflation increases
• Commodities generally do not provide an ongoing stream of income like stock dividends or bond yields, returns are driven by price appreciation

Commodity Markets and Investment Methods

• Commodity markets enable the exchange, buying, and selling of commodities, there are currently about 50 major commodity markets worldwide that facilitate investment in around 100 primary commodities
• Commodity investments can be made through direct physical purchase of the commodity, futures contracts, options on futures, and commodity ETFs or mutual funds
• Commodity futures are often volatile and complex, with high degrees of leverage, investors need to manage leverage, margin, and collateral effectively
• Contango (future prices higher than spot price) and backwardation (future prices lower than spot price) refer to the price difference between futures contracts and the spot price, which can impact returns, contango can lead to negative roll returns

Performance and Risk of Commodities

Diversification Benefits and Return Drivers

• Commodities often have a low or negative correlation with other asset classes like stocks and bonds, providing potential diversification benefits
• Commodity prices exhibit wide price swings and volatility, driven by real-time supply and demand, factors affecting supply and demand include weather, natural disasters, geopolitical events (wars, trade disputes), and changes in production (new discoveries, technological advancements)
• Commodities generally do not provide an ongoing stream of income like stock dividends or bond yields, returns are driven by price appreciation

Risks and Considerations

• Commodity futures are often volatile and complex, with high degrees of leverage, investors need to manage leverage, margin, and collateral effectively
• Contango and backwardation refer to the price difference between futures contracts and the spot price, which can impact returns, contango (future prices higher than spot price) can lead to negative roll returns
• Counterparty risk (risk of default by the other party in the contract), liquidity risk (ability to buy or sell quickly without impacting price), and manager risk (poor investment decisions or fraud) are important considerations with commodity investments

Hedge Funds in Portfolios

Defining Characteristics of Hedge Funds

• Hedge funds are alternative investments that use pooled funds and employ different strategies to earn active returns for their investors
• Hedge funds are typically only accessible to accredited investors and require high minimum investments (often $1 million or more), they also charge both an expense ratio (2% is common) and a performance fee (often 20% of profits)
• Hedge funds use investment strategies unavailable to mutual funds, such as leveraged, long, short, and derivative positions in both domestic and international markets

Strategies and Diversification Benefits

• Strategies used by hedge funds include long/short equity (taking long and short positions in stocks), market neutral (exploiting pricing inefficiencies between related securities while neutralizing market risk), volatility arbitrage (exploiting differences between implied and realized volatility), merger arbitrage (betting on acquisition targets), global macro (taking positions based on macroeconomic trends), and more, each strategy has different risk and return objectives
• Hedge funds offer the potential for portfolio diversification, as their returns are often uncorrelated to traditional asset classes like stocks and bonds, funds of hedge funds provide further diversification by investing in multiple hedge funds with different strategies
• Potential benefits of hedge funds need to be weighed against risks such as leverage (amplifies both gains and losses), complexity, limited liquidity and transparency, and high fees

Hedge Fund Regulations and Due Diligence

Regulatory Requirements

• Hedge funds are subject to regulatory requirements from the Securities and Exchange Commission (SEC), Commodity Futures Trading Commission (CFTC), and other regulatory bodies
• In the U.S., hedge funds are often structured as limited partnerships and are not required to register with the SEC if they have less than $150 million in assets under management
• Registered hedge funds must file a Form ADV with the SEC, providing details on their business, ownership, clients, employees, affiliations, and any disciplinary events
• Hedge funds cannot solicit the general public and can only take money from "qualified purchasers" with at least $5 million in investment assets

Due Diligence Process

• The due diligence process for hedge fund investments includes both quantitative and qualitative assessments covering performance, assets, management, strategy, risk controls, valuation procedures, and more
• Documents to review include the offering memorandum (describes the fund's strategy, risks, and terms), partnership agreement (stipulates the rights and obligations of the general and limited partners), due diligence questionnaire, audited financial statements, and ADV filings
• On-site manager visits and background checks are also part of the due diligence process to assess the fund's operations and verify information
• Ongoing monitoring of hedge fund investments is necessary to assess strategy drift (deviation from stated strategy), style drift (change in investment style), correlation changes, or other red flags (unexpected performance, personnel changes)