Something strange is going on in the world’s hottest market.
I’m convinced investors are missing something. And that gives you an opportunity to place a great bet that could outgun the rampant resources bull market.
I’ve told you about my favourite play on commodities a couple of times now. I think it offers terrific upside potential – and there’s also a ‘safety net’ I believe should help to limit the downside too.
So far, our bet’s been doing okay. But the way commodities have been going up, this fund should be doing better than just okay.
It’s a great example of fickle financial markets – and how they can sometimes offer a good bet for smart investors prepared to take a risk. And that’s what investing is all about, right?
Today I want to take a closer look at the CloseEnhanced Commodities Fund (LSE: CED2) to work out why it’s not keeping up with the markets.
We’re up… but not where we should be
You may remember this fund as I’ve mentioned it a couple of times now. The fund is structured as a bet on commodities. It’s designed to return twice the uplift in a basket of eight commodities. And if these commodities end up below the price when the fund was launched, each share should pay back £1 anyway. (I’ll explain why I say “should” in a moment.)
So far so good. When I first told you about this fund back in August it was trading at just over 90p. At that time, those eight commodities were hovering around the same price as when the fund was launched in 2007. I argued that at those levels the fund offered more or less a ‘free bet’ on the commodities basket.
And that bet is paying off.
Today the commodities are up around 41% and if they stay that way, the fund should pay out £1.82 (£1 plus 2 x 41 = 82p) when it’s wound up in 2013.
And yet what bugs me is that the fund is currently trading at only £1.20.
Share performance since launch (May 2007): | 2007 +2.16% | 2008 -42.65% | 2009 +55.37% | 2010 +26.1%
To put that into perspective, it was trading higher than £1.20 in March 2008 when the commodities basket was only up 25%. Something’s not right here.
So what’s gone wrong? Why isn’t the fund keeping up this time round? And more importantly, does this make it a good bet right now?
Three reasons for the discount
There are three possible reasons I can see for the fund not performing quite as we’d hope.
First, it could all be down to worries over the financial health of the banks behind the bonds and bets. The fund holds bonds with 5 banks and it’s these bonds that will meet the £1 redemption of the fund. If any of the banks go under, it’ll take 20p off the final return to shareholders. If two banks went down, we’d lose 40p and so on. That’s why earlier, I said the fund “should” pay back £1 at redemption, even if commodities fall.
Similarly with the commodities bets, if the counter-party has disappeared, then we won’t collect our winnings.
The second thing that could be affecting the price is that some of these commodities are currently in what’s known as backwardation. That means future prices of the commodities are less than the current spot price. Basically, the markets don’t expect the prices to stay at these heightened levels. And remember, if commodities come off, the fund loses double.
And there’s a third, simple possible reason for the discount. Maybe the markets haven’t noticed the price disparity. It’s not a large, liquid stock. It flies below the radar of most money managers. It could just be that it takes a while for the market to see the opportunity. That’s what The Right Side is all about – finding these opportunities normal investors just don’t spot.
Let’s take a closer look at these three factors. Then I’ll show you why I’m still calling this my top commodities play.
Why I think the market has it wrong.
First of all the question of default can’t be ignored. This fund is the second of its kind. Close’s first attempt was redeemed just over a year ago and should have paid out £2.65. But one of the bets (and bonds) was with failed Icelandic bank Glitnir. In the end, the final redemption came in at £2.14.
But as things stand, the markets aren’t suggesting an imminent failure of any of the banks that we’re relying on. CDS (credit default swaps) are a kind of insurance policy against bank failure. If any of our banks were about to fail, its insurance policy would be sky high – and they aren’t. So I don’t think that’s a good reason to hold this fund down.
Next, what about the commodities themselves – will recent price hikes reverse? Well, there’s no doubt that some of the price rises in the agricultural commodities have been down to adverse weather. This has wreaked havoc with global harvests and driven prices up. Those price hikes could be undone when the weather patterns revert to more normal ones.
But don’t forget, commodity price rises are also due to huge new demand from Asia. As economies grow, people get richer and they demand ever more food. And it’s not just because they eat more, it’s because diets skew towards meat – and meat production absorbs a lot of grain, for example.
And don’t forget the influence of quantitative easing (QE). Newly minted dollars are heading into natural resources. So all in all, I’ve got a feeling that the rise in commodities inflation will be hard to turn around. We’re in a commodities ‘super-cycle’ – who knows how long it could go on?
All of which means that come June 2013, prices could be considerably higher – and remember, with this fund, we’re getting paid double these rises… if I were on the other side of those commodities bets, I’d be worried.
And lastly, is it just that the markets don’t know about this fund and its opportunity? It’s certainly true that the CloseEnhanced Commodities Fund isn’t well known. Structured as an investment trust, it doesn’t get much coverage from investment managers (they don’t make any commissions) or newspapers. This is probably a factor. But remember, last time the commodities raced up, the shares followed the market higher. So I’m not convinced by this argument.
In all probability, each of the three factors plays a part in holding the shares back. So let’s put it all together…
On balance it still looks like a great bet
The fund was launched with a six-year term. And now there are only two and a half years left to run. Every day we get closer to redemption the fund looks better – especially if the commodities keep on trading up.
This fund was launched back in May 2007. That was before the market crash, before global QE and dollar debasement. And even with the global crash, commodities pretty soon recovered their upward momentum. I would say that the ‘rules of engagement’ have changed in our favour…
On balance, I reckon this is still a great bet. Sure there’s risk – you should never blithely ignore something the market is trying to tell you. As with any bet, only put down money you’re prepared lose.
But for a chance to capture double the upside move in what looks like a strong bull market, I think this is a great bet to take.
The question is: how good do the odds look to you?
P.S. Before I leave, here’s something you should check out if you’re into a little short-term trading. I’ve just been given a heads-up from the guy running this system that he could close the doors to new entrants at any time.
After the cult success of his Forex Net Trap System, Richard Hill has recently revealed his new, beta-tested and personally proven evening trading strategy…
“Spare ten minutes during the News at Ten to raid the forex markets for “£140, £56 or even £420 tax-free”
This system is already in huge demand. The feedback from people using it is phenomenally good. But there is a problem. The guy behind it wants to ensure that he is able to give his full support to everyone who signs up. That’s why he is strictly limiting the number of copies released.
He told me this morning:
“Ask your readers to act quickly if they want to try this. I might close this down to new entrants at any time. Then I will only reopen it if I am comfortably covering the support that I promise. No guarantees.”
This guy has a great reputation. His new system could just be what gets your trading into another league. And it sounds like it’s very simple to use.
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Managing Editor: Theo Casey. The Right Side is issued by MoneyWeek Ltd. MoneyWeek Ltd is authorised and regulated by the Financial Services Authority. FSA No 509798. https://www.fsa.gov.uk/register/home.do