What to Know About Investing in Commodities

If you’ve been part of the investing community for any length of time, chances are, you’ve heard about commodities. These basic goods are essential to much of modern life – if you’ve ever eaten grain, driven a car, or slathered a slab of beef in steak sauce, then you’ve enjoyed the end results of the commodities markets.

But what are they in terms of investing

TL;DR

In investing, a commodity may take one of four basic forms:

  • Energy commodities – such as oil, natural gas, solar farms, or wind farms
  • Precious metals – including gold, silver, platinum, and other mined goods
  • Livestock – primarily cattle, pigs, and poultry in the United States
  • Agriculture – like grains, corn, and soybeans

Additionally, there are multiple ways to invest in commodities. For example, you can check out futures contracts, stocks, and ETFs. Additionally, individual investors may buy stakes in a mutual fund or commodity pool.

Commodities are typically risky investments due to the layers of global interconnectedness and market interactions. Depending on the commodity, risks run the gamut from international politics to a mining collapse. However, for those with the money and patience to invest, there can be great rewards – in the right circumstances.

Commodities in Investing

Investors often speak of commodities as a way to diversify their portfolios outside of traditional investments. Some investors trade them regularly, but others may join only during times of market volatility to buffer against unwanted stock movements.

While bartering markets have been based on trading commodities for thousands of years, investors can purchase modern them on exchanges (similar to securities). Nowadays, a commodities exchange may refer to both the legal entity that enforces the rules of trade, as well as the physical location where traders buy and sell the commodities.

Q.ai says: There are two main types of commodities that you divide into four categories:

  • Hard ones require mining or drilling; this category is further divided into energy and precious metals.
  • Soft ones are those that you must ranch or grow; this category includes livestock and agricultural products.

Unusually, all commodities are treated equally in their class. For instance, a cow is a cow, regardless of the ranch it comes from. Similarly, precious metals or oils are traded at the same value, even if they come from different mines or countries. This perception of uniformity is what makes them investable assets.   

Commodities Markets

While investing in commodities used to be left to the professionals, modern technology has allowed for more individuals to trade in the big leagues.

Commodities markets are unusual in that they are governed by the “real world” version of supply and demand. This is a contrast to stock markets, where supply and demand is governed by investor interest and the issuing organizations. For example, the price of raw metals depends largely upon the need of countries with large manufacturing sectors, such as China.

As a result, supply and demand drives commodities markets, rather than traders’ whims. Thus, low supply means higher prices, while low demand drives prices down. But this doesn’t mean that these markets are always predictable. Issues such as global economic and political issues may impact the price of commodities. Additionally, natural disasters, pandemics, and even mine collapses may affect the price of a particular commodity.

Investing in Commodity Types

There are five basic ways to invest in them:

  • Commodity futures
  • Commodity pools
  • ETFs and ETNs
  • Stocks
  • Mutual funds

We’ll cover each of these more in depth to get a better understanding of their mechanisms, risks, and benefits.

Futures Contracts

Futures contracts are mostly used by commercial and institutional investors with a need for the raw commodity. These legal agreements set terms for traders and sellers to exchange the goods for a predetermined price at a set point in time.

Q.ai says: Manufacturers and service providers rely on futures contracts to budget for the upcoming year, as well as to lock in prices before unfavorable fluctuations. Examples may include:

  • Fuel purchases in the airline sector
  • Food manufacturers pre-purchasing grains, coffee beans, or meat
  • Smelters ordering metals from a new mine

Speculative investors (advanced traders looking to profit from price changes) may also trade futures contracts. However, as they have no need for the goods, they usually close the contract before delivery. Another way investors may trade is with futures options, which gives the right but not the obligation to exercise their contract.

There are a few unique benefits to futures compared to other investments. For one, it’s easier to analyze your investment, as the terms are spelled out in your contract. Plus, you can take either long or short positions – which gives you the potential to see huge profits on little capital. In fact, due to the global interconnectedness of the market, it’s possible to see a futures contract double in a matter of seconds.

However, there are significant risks to consider. For instance, while a contract may see excessive gains, the inherent volatility of commodities markets means that your principal may also be wiped out in seconds. Furthermore, the minimum deposit clause on many futures contracts is contingent upon markets rising. Thus, if the market falls instead, an investor may no longer meet the minimum deposit requirement. In these cases, investors will either have to pony up additional cash – or see the contract closed out.

Commodity Pools

Another way to get started investing in commodities is to put funds into a commodity pool. In these arrangements, a CPO – commodity pool operator – gathers money from investors to buy a futures contract or option. CPOs must abide by certain regulations, such as:

  • Keeping detailed records
  • Providing annual financial reports
  • Giving investors access to quarterly account statements

Typically, a CPO employs a CTA (commodity trading advisor) to offer investing advice. These situations come with the advantage of having a licensed professional on hand to help manage investments. Plus, smaller investors with less capital can purchase a stake in larger contracts to seek larger gains.

ETFs, Notes, and Commodity Types

ETFs (exchange-traded funds) and ETNs (exchange-traded notes) are another commodity investing opportunity. Like stocks, these investments allow investors to profit from price fluctuations – without the risk of signing a futures contract.

When it comes to commodity ETFs, these funds track the price of a particular commodity or sector using futures contracts as their baseline. Others may back their fund by holding the commodity in storage.

On the other hand, ETNs are unsecured debt securities that mimic the fluctuation of a commodity or index. These investments are backed by the issuer. While they let investors participate in the commodities market without a special brokerage account, they do come with a higher credit risk.

Furthermore, while these investments trade like stocks, not every commodity has an ETF or ETN. And just because an underlying commodity moves, that doesn’t mean the fund will benefit from price changes.

Stocks and Commodities

More commonly, investors get involved with commodities markets by purchasing the stock of companies that engage in their production. For instance, energy investors may put their money into mining corporations or solar farms. Or people who are interested in agriculture may invest in farms or slaughterhouses.

One of the biggest advantages of stocks over futures options is that there is more information available. Plus, they’re more liquid, as you’re more likely to find an investor who wants to buy out your stock position (as well as a broker to facilitate your trades). Not to mention, stocks are less prone to volatility than futures contracts.

On the other hand, investing in commodities stocks is not the same as playing on the market. Just because the price of gold does up doesn’t mean your preferred mining company will realize gains. Furthermore, there are plenty of company-related factors that may influence the price of a stock outside the global factors that influence the price of the physical commodity.

Mutual Funds and Commodities

Unlike commodities futures and stocks, mutual funds don’t directly invest in them. However, there are a handful of mutual funds that invest in:

  • Stocks from commodity-related industries
  • Commodities futures contracts
  • Commodity-linked derivatives and securities

Of course, this doesn’t mean that mutual funds are “safe” or risk-free; like all investments, there is a chance of losing your principal. Additionally, they tend to come with higher management fees and sales charges than ETFs, which can eat into potential profits.

Risks and Benefits of Investing in Commodities

Regardless of the specific security, there are unique risks and benefits of investing in commodities. This is especially true for individual investors who have less cash on hand than large institutions.  

Benefits

  • Diversification: They provide investors a unique chance to diversify out of traditional investments. This, coupled with the fact that they often move in opposition to economic instability, can help hedge against economic downturn.
  • Gains: They have the potential to turn a hefty profit in the right situations.
  • Hedge against inflation: Inflation often spells higher prices for them – which means that as stocks and bonds lose value, these investments gain in value.

Risks

  • Volatility and principal risk: They can be extremely volatile, which puts you at risk of losing your principal for factors outside your influence.
  • Foreign market exposure: Many have roots in foreign and emerging markets (especially natural gas, oils, and mined minerals and metals). Thus, investing in them automatically exposes your portfolio to foreign markets, which carries its own risks.
  • The chance a company won’t follow through: If the seller (in the case of a futures contract) can’t deliver the goods, whether due to internal or external factors, then a particular contract may plummet in price – even if the price of the commodity is going up.
  • Asset concentration: While investing in them can add diversification, investing solely in them runs the risk of putting too many eggs in one basket. Any massive shift in the price of a single commodity can wipe out your portfolio, even if you have your risk spread amongst multiple commodity-related securities.

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