Investors looking for ways to diversify their portfolio outside of the more traditional asset classes associated with stocks and bonds will, at times, turn to commodities.
Historically, commodities have provided performance that often diverges from the stock and bond markets. “From a tactical perspective, commodities can offer opportunities from time-to-time,” says Rob Haworth, senior investment strategy director for U.S. Bank Wealth Management. “This is best in circumstances where a broad commodity complex is in short supply, driving up prices.” The 2021-2022 surge in energy prices demonstrates the impact of an imbalance between supply and demand.
You can invest in commodities in more than one form and with more than one product. There are futures contracts, exchange-traded products and mutual funds. One of the appeals of commodities is the range of products available. For example, you can invest in agriculture, natural resources, precious metals and livestock. You may also simply buy physical raw commodities, such as gold or silver.
Why invest in commodities
Commodities may minimize portfolio volatility. Weather, politics or global production can affect commodities returns, so the historical correlation of commodities to traditional assets is low. As a result, the returns from commodities may help reduce volatility in a diversified portfolio.
Commodities can be a hedge against inflation. Commodity prices often follow inflation and may provide a defense against the impact of rising prices. Read more about the effect of inflation on investments.
Commodities can be physical assets. Hard commodities, such as gold, may be considered a store of value. This is especially the case when a base level of demand exists. As demand rises, there may be potential for price increases.
“Commodities can offer opportunities from time-to-time. Investing is best in circumstances where a broad commodity complex is in short supply, driving up prices.” - Rob Haworth, senior investment strategy director for U.S. Bank Wealth Management
How to invest in commodities
As an investment, commodities come in many forms. Some can be as complex as direct ownership of physical commodities or as easy as purchasing a mutual fund that focuses on commodities.
Physical ownership. This is the most basic way to invest in commodities. But unless these are small, transportable assets like precious metals, it can be impractical. It’s not reasonable or desirable for individual investors to store bales of cotton or barrels of frozen orange juice concentrate. Owning these types of commodities is usually best left to those who will be turning that commodity into a finished product.
Futures contracts. Futures originated as a way for farmers to set a price for future delivery of goods. These contracts are perhaps the most well-known method for investing in commodities. Futures contracts have price-mechanism transparency, and you can access a commodity futures contract for a small fraction of its value, but there are risks involved.
Buying and selling futures contracts requires skill and experience. If the forward price, or what you paid for the contract, is higher than the spot price when the contract comes due, you’ll lose money.
Individual securities. Shares of commodity-producing companies grant you indirect access to the commodity markets. If the commodity rises in price, the companies producing that commodity may experience increased revenues and profits. “If someone invests in stocks of oil companies, there tends to be a relationship to oil price trends over time, but sometimes there is a disconnect,” says Haworth. This is one limitation of relying on individual securities as a way to diversify into commodities.
Mutual funds, exchange-traded funds (ETFs) and exchange-traded notes (ETNs). These securities can provide you wide exposure with relatively low investment minimums. Funds can be specific to a particular commodity, such as gold or precious metals, or cover a broader array of commodities. “Funds are invested in futures contracts and don’t own physical commodities,” notes Haworth.
Alternative investments. Hedge funds or private investments specializing in commodities are an option. These are highly speculative and leveraged investment strategies, carrying a high degree of risk and volatility. Enhanced returns are a possibility, but there is no guarantee of success. It’s a good idea to work with a financial professional before taking this approach. Read more about these two types of alternative investments.
Common commodities terminology
If you’re thinking about investing in commodities, it’s good to know the terms of the trade. Here are some key terms associated with trading commodities.
Commodity: Raw materials and unprocessed goods that are either consumed directly or are processed and resold, such as gold, oil, wheat, cattle and aluminum.
Forward price: The agreed-upon price of an asset in a forward contract where prices are set now but delivery and payment will occur at a future date.
Futures: An exchange-traded derivative. A future represents an obligation to buy or sell some underlying asset in the future for a specified price.
Index performance: Most commodity ETFs/ ETNs and mutual funds track a commodity index like the S&P GSCI. Investors should be aware that indices don’t always track with spot prices of specific commodities.
Spot price: The price quoted for immediate payment and delivery of a specific commodity. This price applies only to delivery.
Setting proper expectations
Haworth cautions that commodities should only play a limited role in your portfolio, perhaps used more as a tactical strategy for certain economic or market environments. “Broad commodities probably shouldn’t be part of a long-term portfolio strategy,” says Haworth. “You’re not sufficiently compensated for the risk. They may generate equity-like returns, but typically with much more volatility and unpredictability.”
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Article initially appeared on usbank.com
Credit: usbank.com, WSJ.com, CBE
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