What is commodity investing?
Commodities are raw materials that are either consumed directly, such as food, or used as building blocks to create other products.
Investing in commodities
There are several ways to consider investing in commodities. One is to purchase varying amounts of physical raw commodities, such as precious metal bullion. Investors can also invest through the use of futures contracts or exchange-traded products (ETPs) that directly track a specific commodity index. These are highly volatile and complex investments that are generally recommended for sophisticated investors only.
Another way to gain exposure to commodities is through mutual funds that invest in commodity- related businesses. For instance, an oil and gas fund would own stocks issued by companies involved in energy exploration, refining, storage, and distribution.
Commodity stocks vs. commodities
Do commodity stocks and commodities always deliver the same returns? Not necessarily. There are times when one investment out performs the other so maintaining an allocation to each group might help contribute to a portfolio’s overall long-term performance.
Advantages of commodity investing
Diversification
Over time, commodities and commodity stocks tend to provide returns that differ from other stocks and bonds. A portfolio with assets that don’t move in lockstep can help you better manage market volatility. However, diversification does not ensure a profit or guarantee against loss.
Potential returns
Individual commodity prices can fluctuate due to factors such as supply and demand, exchange rates, inflation, and the overall health of the economy. In recent years, increased demand due to massive global infrastructure projects has greatly influenced commodity prices. In general, a rise in commodity prices has had a positive impact on the stocks of companies in related industries.
Potential hedge against inflation
Inflation—which can erode the value of stocks and bonds—can often mean higher prices for commodities. While commodities have shown strong performance in periods of high inflation, investors should note that commodities can be much more volatile than other types of investments.
Risks of commodity investing
Principal risk:
Commodity prices can be extremely volatile and the commodities industry can be significantly affected by world events, import controls, worldwide competition, government regulations, and economic conditions, all of which can have an impact on commodity prices. There’s a chance your investment could lose value.
Volatility:
Mutual funds or exchange-traded products (ETPs) that track a single sector or commodity can exhibit higher than average volatility. Also, commodity funds or ETPs that use futures, options, or other derivative instruments can further increase volatility.
Foreign and emerging market exposure:
Apart from the risks associated with commodity investing, these funds also carry the risks that go along with investing in foreign and emerging markets, including volatility caused by political, economic, and currency instability.
Asset concentration:
While commodity funds can play a role in a diversification strategy, the funds themselves are considered non-diversified as they invest a significant portion of their assets in fewer individual securities that are generally concentrated in 1 or 2 industries. As a result, changes in the market value of a single investment could cause greater fluctuations in share price than would occur in a more diversified fund.
Other risks:
Commodity focused stock funds may use futures contracts to track an underlying commodity or commodity index. Trading in these types of securities is speculative and can be extremely volatile, potentially causing the performance of a fund to significantly differ from the performance of the underlying commodity. That difference can be positive or negative, depending on market conditions and the fund’s investment strategy.