What is “Commodities Investing”?
Commodities are an essential part of the economy as businesses need these raw materials to produce goods. Commodities can be metals (such as gold, silver, or copper), minerals, or agricultural products (such as cotton or wheat), some of which can be directly consumed. Investing in commodities used to be complex and only accessible for sophisticated investors, but nowadays individual investors are presented with many options to gain exposure. Some of the most popular commodities include precious metals such as gold and silver, oil and gas, cotton, or wheat.
Key Learning Points
- Investing in commodities is considered a higher risk, but can offer excellent portfolio diversification benefits as their price tends to move inversely to the price of other traditional asset classes such as equities
- Commodities supply and demand can be heavily influenced by factors that are difficult to predict such as natural disasters or pandemics – thus investors may expect higher volatility relative to the overall market
- Most commodities trade on exchanges such as the Chicago Board of Options Exchange (CBOE) and the Chicago Mercantile Exchange (CME)
- Investing in commodities can be a good hedging strategy against inflation as rising prices can erode the returns from bonds and equities
- There are various ways to gain commodity exposure – most traditional options include stocks, mutual funds or exchange-traded commodities (ETCs), but higher risk investors could also consider synthetic exposure through products such as contracts for difference (CFDs)
There are three key selling points for commodities investing. First, they tend to show a lower correlation to traditional asset classes such as equities and bonds and therefore can bring diversification benefits when added to a core portfolio. Commodities are also the place where investors usually go should inflationary pressures start to occur as in most cases it is the supply shortage (and increasing price respectively) that creates rising prices of goods for the end-client.
Last but not least, commodities could potentially deliver returns in excess of the market average, but they are highly volatile and typically perform well during the recovery stage of the business cycle. Therefore, investors should be cautious if allocating a larger proportion of their portfolio to the asset class.
Commodity prices can be highly volatile due to a number of factors that are difficult to predict: pandemics, unusual weather patterns, government regulations, and economic conditions to name a few. In addition, investing in commodities can also give a reasonable indirect exposure to emerging markets (where they are sourced), and therefore additional political, economic, and foreign exchange risks may be involved. Some commodity investment strategies tend to use derivatives such as futures contracts in order to track the underlying commodity. However, these types of securities are highly speculative and the performance of the strategy may shift from that of the underlying commodity.
Commodity Investment Instruments
The most accessible instruments for individual investors to gain exposure to commodities are equities, mutual funds, and ETCs. One option is to buy shares of companies that operate in the commodity space such as miners or oil producers. These companies’ stock prices tend to be highly correlated to the underlying commodity prices. For those who favor more passive exposure, ETCs offer to track an underlying commodity and could be purchased and sold just like normal shares. There are two most common structures that ETCs use – either physically holding the commodity (popular with precious metals investors, where metal bars are held securely in a vault) or by investing in derivatives.