What to Know About Investing In Commodities

·7 min read

As commodity prices rise, this alternative asset class to traditional stocks and bonds is capturing the attention of investors.

Commodities are the raw materials that are either consumed or used to build other products. From orange juice to cotton, oil and gas to gold, commodities take many forms.

As the U.S. economy rebounds from pandemic-induced lockdowns and spending rises across the board, commodity demand is increasing. That's a big shift from last year when commodity prices fell, and oil prices were negative, says William De Vijlder, group chief economist of BNP Paribas.

Some commodities, such as gold, may be reflecting increased inflation concerns with the economy flush with fiscal and monetary stimulus. Other commodities, such as copper, De Vijlder says, are seeing a structural demand shift since the metal is used in products like electric vehicles and other infrastructure built to combat climate change.

If you're interested in investing in this space, here are a few common questions that will likely come up:

-- How do you invest in commodities?

-- What should investors know about commodity trading?

-- Why is it risky to invest in a commodity?

-- Is investing in this type of asset right for you?

-- How do you allocate commodities in a portfolio?

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How to Invest in Commodities

There are several ways to invest in commodities, says Will Rhind, CEO of GraniteShares, an exchange-traded fund issuer. Investors should consider the following options.

Buy stocks and bonds of commodities producers. A practical way to invest in commodities is to buy the stocks and corporate bonds of commodity producers. Many of them are members of the S&P 500, such as oil giant Exxon Mobil Corp. (ticker: XOM) and agricultural producer Archer-Daniels-Midland Co. ( ADM). Other big commodity-producing companies are non-U.S. firms. Melbourne, Australia-based BHP Group ( BHP) operates in more than a dozen countries and extracts various commodities from oil and gas to coal, copper and iron ore -- it's one example of a commodity stock that spans the globe. Another example is Barrick Gold Corp. ( GOLD), a Toronto-headquartered metals miner with international interests and gold and copper mining activities.

Buy a commodity ETF. Rhind notes there are several types of commodity ETFs. Some are indexes of commodity producers, such as the VanEck Gold Miners Equity ETF ( GDX), while some invest in the commodities themselves, such as the GraniteShares Gold Trust ( BAR) and the iShares Silver Trust ( SLV).

Some commodity ETFs invest in commodity futures -- a futures contract is an agreement to buy or sell a particular commodity at a predetermined price at a specified time in the future. The iShares S&P GSCI Commodity-Indexed Trust ( GSG) tracks the S&P GSCI, formerly the Goldman Sachs Commodity Index, which comprises several commodity futures markets.

Buy physical commodities. The easiest way for investors to gain exposure to physical commodities is to buy precious metals such as gold, silver, platinum and palladium. These are available in coin and bar form from precious metals dealers. To find a reputable dealer, check to see if the dealer is a member of metals industry groups such as the Industry Council for Tangible Assets or Professional Numismatists Guild.

Commodities can be an inflation hedge. The current supply/demand shortage for many items, from semiconductor chips to beef, has many people worried about inflation. Tom Essaye, newsletter editor of the Sevens Report, says of the major asset classes -- stocks, bonds and commodities -- commodities are the most highly correlated to inflation, and commodity ETFs have traded well during periods of rising inflation.

He says investors interested in commodities as an inflation hedge could look to an ETF such as First Trust Group Tactical Commodity Strategy Fund ( FTGC), which has roughly $1.5 billion in assets under management and balanced exposure to agriculture, energy and metals. Additionally, at tax time, investors receive a 1099 form. Some commodity ETFs issue K-1 forms, which can cause additional work when filing taxes.

What to Know About Commodity Trading

Commodity trading is done on futures exchanges, such as the CME Group or Intercontinental Exchange, commonly known as ICE. Futures trading is usually the realm of professional traders, Rhind says, because it's a derivative. A derivative's value depends on the value of the underlying asset, such as crude oil or wheat.

Futures trade on margin, which is the collateral a trader puts up to trade futures contracts and is a percentage of the security's price. There is the initial margin to open a position and the maintenance margin to keep the account active. Commodity futures trading can be highly volatile, and traders can lose more than their principal, especially if prices fall significantly since the exchanges will make margin calls, requiring traders to put up more money to make the account whole.

Also, futures contracts have expiration dates, and traders must manage the rolling of the contracts, that is moving a position from an expiring contract to a new one, Rhind says. If a trader lets the contract expire, they must take delivery. Sometimes contracts are cash-settled, meaning the trader receives the monetary value of the contract, but some are physical delivery, which means the trader receives real goods of the underlying asset. "That could be gold, or that could be live cattle," he says.

[Read: What Are Mutual Funds? The Ultimate Guide.]

The Risks of Investing in a Commodity

Investing in the commodities market brings risks that are distinct from the perils of the stock market or bond market, as many variables affect commodities pricing. The factors that influence the orange juice market are much different than those that affect soybeans or lead. For example, weather plays an important part in agricultural markets and has little impact on energy and metals, Rhind says.

In this space, prices are extremely volatile. Within a short time, commodity prices can peak and trough dramatically.

Since many commodities are international in nature, investment returns are also affected by changes in the exchange rates between foreign currencies and the U.S. dollar. Being a global market, there's potential for intervention, such as OPEC setting oil prices, Rhind says.

Should You Invest in Commodities?

This type of investing is risky and comes with tremendous volatility. The lack of correlation between commodities and typical stock and bond investments can be helpful at certain times, though commodity returns can drag down an investor's total returns during other periods.

Commodities investing is cyclical and distinct, so commodities offer varying returns. Over the past 10 years, the S&P GSCI index price peaked in 2012 near 713 and bottomed in April 2020 at around 230 -- mostly dragged down by weak oil prices. It currently trades around 530.

Individual commodities also follow their own ups and downs in price.

TYPE OF COMMODITY

PERFORMANCE (2019)

PERFORMANCE (2020)

Aluminum

-4.38%

10.8%

Coal

-18.02%

-1.29%

Copper

3.36%

26.02%

Corn

3.4%

24.82%

Crude Oil

34.46%

-20.54%

Gold

18.31%

25.12%

Lead

-4.66%

3.25%

Natural Gas

-25.54%

15.99%

Nickel

31.55%

18.66%

Palladium

54.21%

25.86%

Platinum

21.48%

10.92%

Silver

15.21%

47.89%

Wheat

11.03%

14.63%

Zinc

-9.49%

19.73%

The above data from U.S. Global Investors shows the range of individual commodities returns. Notice that crude oil gained nearly 35% in 2019 but fell more than 20% in 2020. Palladium rose about 54% in 2019 and nearly 26% in 2020. Corn was up 3.4% in 2019 but gained 24.82% in 2020. These disparate returns are the norm among individual commodities.

Portfolio Allocation

Financial advisors maintain varying opinions on commodities investing. Viewing commodities as a whole misses the distinct variations in individual commodity performance. For instance, in 2020 -- when the S&P 500 finished nearly 18% higher including dividends -- wheat rose by 14.63%, copper jumped 26.02% and silver leaped 47.89%, according to U.S. Global Investors.

Many advisors recommend a small exposure to commodities to offset the volatility in stocks and bonds. A 5% interest in a diverse commodity fund is a reasonable allocation.

Picking specific commodity investments like betting on the direction of wheat or oil futures is quite speculative and best left to the professionals. Do-it-yourself investors are best served by investing in broad commodity funds unless they have specific knowledge about a particular commodity.

Debbie Carlson has more than 20 years experience as a journalist and has had bylines in Barron's, The Wall Street Journal, the Chicago Tribune, The Guardian, and other publications. Follow her on Twitter at @debbiecarlson1.

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