Commodities are considered alternative investments because they don’t fall into the main categories of stocks, bonds or cash.
These internationally traded raw materials often form relatively small portions of retail investor portfolios. But they can serve important roles, such as hedging against inflation or being a safe haven amid market worries.
While commodities can exhibit strong short-term gains, their short-term losses can also be sharp. Speculators often try to time these fluctuations, but long-term holders understand that the primary allure of these raw materials is their ability to provide diversification.
“Commodity investments have a place in any diversified portfolio, often providing very different risk profiles to traditional equities or fixed income,” said Lucas Kiely, chief investment officer with digital wealth management platform Yield App. “As such, they will always be with us, but unlikely to shoot the lights out.”
Understanding commodity investing
While each commodity has its particular price drivers, one commonality is volatility.
That’s because commodities are tied to economic cycles. When economies are doing well, or when they are expected to improve shortly in the future, industrial commodities like copper and crude oil can outperform because of increases in demand or speculative trading.
Agricultural commodities, such as soybeans, wheat or livestock, are also subject to supply and demand.
Supply can be even more fickle for agricultural commodities than for metals, as planting cycles are much shorter than mine development and life cycles. And unlike metals, agricultural products are always subject to the whims of nature, whether it be drought or floods.
Popular commodities for investment
According to Bob Minter, director of ETF investment strategy at abrdn, a global asset management company, the top-five most popular commodities are oil, natural gas, gold, silver and copper.
Of these, oil has the biggest market, but gold is the most popular commodity for holding long term because of its role as a risk hedge, according to Minter.
A portfolio of these commodities would span the energy market, with its dynamics including transportation and home heating; industrial metals with their dependence on manufacturing cycles; and precious metals with their reliance on financial market dynamics.
What factors influence commodity prices?
Economic cyclicality
The reason commodities are particularly volatile investments is because most of them are highly correlated to economic cycles.
Copper is a prime example of dependence on economic cyclicality. The red metal is sometimes referred to as “Dr. Copper,” as if it has an advanced degree in economics, because it is used in so many industrial applications.
Global politics
“Risk profiles vary depending on what you’re investing in,” Kiely said. “Oil, for example, is heavily influenced by global politics, and prices can spike pretty wildly depending on tensions in oil-producing areas, of which there are often many.”
Supply & demand
“The price of oil, gold, silver, copper and others are only based upon supply versus demand,” said Steven Conners, president of Conners Wealth Management. “This can make them riskier, especially if supply exceeds demand. If there is a shortage of a commodity, the price can appreciate notably.”
However, gold is influenced by supply and demand in a much different way than industrial metals or energy commodities are. Supply is heavily influenced by mine output. But demand is often driven by financial interests of central banks and investors rather than raw industrial demand.
Industrial applications
Other metals, including silver, platinum and palladium, can also function as precious metals for investors. But they also have much wider industrial uses than gold does, giving the yellow metal a unique role in the global financial system and investor portfolios.
One of the biggest factors affecting commodities investing is economic activity in China. That’s because the Asian nation’s huge population and role as a key global manufacturing center mean it is a huge source of demand for industrial metals, coal, soybeans and many other commodities. It is also a large center for gold demand.
“Over 50% of global commodity demand is generated inside China, making the outlook there critical to commodity direction,” Minter said. “Current consensus is for 4.6% economic growth in China, hardly a recession.”
Different methods to invest in commodities
One of the main methods for investing in precious metals is through physical ownership of bars and coins. But those have to be stored and insured, which cuts down on any gains from price appreciation, the only way to make money via bullion.
Still, for most investors, holding gold in a safe deposit box at the bank is probably easier than holding grain in a silo.
“It is difficult to hold a diversified commodity position physically due to agriculture spoilage, maintenance on energy storage, etc.,” Minter said.
That’s where getting commodities exposure through financial markets comes into play. Depending on their level of sophistication, investors often do this through futures, stocks and funds.
“Most investors access the commodity markets through ETFs or sector-specific stocks, but professional investors use the commodity futures exchanges to trade underlying futures,” Kiely said.
Futures
All sorts of commodities are traded in futures markets around the globe, including industrial and precious metals, soft commodities like cocoa, wheat and soybeans, and energy commodities like crude oil.
Some of the complications with futures involve using margin and understanding rolling over contracts instead of taking delivery, which most investors do not want to do.
“Commodities can … be held via futures ownership, which because they are a timed contract, must be rolled constantly and monitored prior to expiration,” Minter said.
Stocks
Buying stocks of commodities companies probably will feel more familiar to most investors.
But buying shares in an oil company or a copper miner come with their own risks, and these stocks can lag — or outperform — their underlying commodities.
“You also can own commodities via commodities-related equity but then incur operational risk of the company, for industrial accidents, labor strikes, management decision mistakes,” Minter said.
Exploring commodity ETFs and ETCs
Equity-backed ETFs
One way to deal with company-specific risks while also investing in certain commodities themes is through exchange-traded funds (ETFs) backed by commodity-related equities.
These financial instruments wrap many different stocks under a single ticker symbol that trades like a share of a company. Mutual funds are similar in that both are pooled investments, but mutual funds only price once per day, while ETFs trade throughout the day like stocks.
“The best way for most investors to invest in commodities is to take a smaller percentage of your portfolio and use a mutual fund or exchange-traded fund to gain exposure,” Conners said.
Physically or futures-backed ETFs and ETCs
Commodity ETFs aren’t limited to equities investments, however.
Some are backed by physical metal held in warehouses, while others are backed by futures.
Also traded like stocks, exchange-traded commodities (ETCs) are financial instruments that are essentially asset-backed bonds. Their performance is linked to the performance of commodities futures, or to the spot price of a commodity, which is the price for immediate delivery instead of delivery at some future point.
ETCs are structured as notes underwritten by a bank and backed by commodities as collateral.
The appeal of ETCs and ETFs is that they offer exposure to commodities without the hassle of storing gold yourself or entering the complicated oil futures markets, for example.
Risks associated with commodity investing
The primary risk of investing in commodities is that the volatility won’t go your way.
In other words, buying a commodity in hopes of price appreciation might go sour if demand prospects don’t pan out as you hoped. Or, if you short shares of a commodities producer and that company ends up outperforming, you’re also out money.
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How to trade commodities
There are several ways to access the commodities market depending on your goals, time horizon and risk tolerance.
Buy precious metals online
Trading commodities can be as simple as buying coins or bars made from gold, silver or other precious metals from an online dealer like Kitco or BullionVault.
Use your brokerage account
If you’re already investing in the stock market, then you have a brokerage account. That’s probably all you need to invest in equities of gold miners or oil companies or the ETFs that hold them under one ticker symbol.
If you want to trade futures, you may be able to do it at your existing brokerage with special approval. There are plenty of online brokerages and trading platforms where you can trade futures.
Trade futures on a commodities exchange
There are many different futures exchanges around the world. CME Group, for example, owns a suite of exchanges where you can trade many products, including copper, gold, corn, hogs and cattle. Another option is Intercontinental Exchange’s US unit where you can trade commodities products, such as coffee, cocoa, sugar, cotton, wheat, canola, coal and crude oil.
Each exchange maintains a long list of commodities trading products on its website.
Getting more exotic, you can trade red beans on a Japanese exchange, skim milk powder in Singapore, purified terephthalic acid in China and palm oil in Malaysia.
Frequently asked questions (FAQs)
Among the most popular commodities cited by Minter, the highest returns over the last year belonged to gold, which “has been influenced by foreign central bank purchases … to diversify away from the US dollar,” he said.
Meanwhile, natural gas produced the lowest returns, he said, as the commodity “has been influenced by three consecutive abnormally warm winters in Europe and two warm winters in the US, which reduce home heating demand.”
While each commodity is unique, Minter said three themes dominate the general commodity outlook currently.
Physical inventories are low in a number of commodities, investor sentiment is very negative in many commodities and China has been adding incremental stimulus that is starting to improve the economy there, he said.
“Money managers have shorted commodities to an extreme level,” Minter said. “History shows extreme negative positioning can cause large price gains when it is normalized.”
