Roger Wohlner is a writer and financial advisor with over 20 years of financial services experience. He writes about financial planning for Wealthsimple and for a number of financial advisors. His work has been published in Investopedia, Yahoo! Finance, The Motley Fool, Money.com, US News among other publications. Roger owns his own finance blog called 'The Chicago Financial Planner'. He holds an MBA from Marquette University and a Bachelor’s degree with an emphasis on finance from the University of Wisconsin-Oshkosh.
Commodities are items that occur naturally in several broad categories: metals (aluminum, gold, silver), energy (oil, natural gas, heating oil) agriculture (cotton, corn, wheat, soybeans, oranges, sugar and lumber), and livestock and meats (cattle, hogs, pork bellies). They’re an asset class available to investors, just like traditional stocks, bonds and cash.
Commodities are traded on exchanges via futures contracts, allowing those who use these and other commodities in the course of their normal business activities lock in prices at which they can buy or sell the commodity at some point in the future. They can also be a way for producers to hedge prices. For example, a farmer might buy or sell futures contracts to hedge their corn crop or the value of their live hogs in an effort to lock in a profit.
Investors can trade these futures contracts in an effort to benefit from the movement of the price of the underlying commodity. They’re not looking to take delivery of the physical commodity—the last thing an investor living in a luxury condo in Chicago’s Gold Coast wants is a herd of live cattle delivered to the front door of the building. They’re simply speculating on the future price of these items.
Ways to start investing in
There are a few different ways to invest in commodities:
Mutual funds and ETFs offer the advantage of convenience, but many of these types of managed investment vehicles invest in stocks of commodity-related companies versus the actual commodity.
For example, a gold and precious metals mutual fund may invrest in the stocks of companies involved in the mining of these precious metals as well as in various stages of processing refining and selling the metals. While the fortunes of these companies are at least in part tied to the price of the metals, the diversification benefit to your portfolio may be limited compared to an investment more tied to the actual commodity.
There are a few ETFs that hold physical commodities in the precious metals space. In this case the ETF firm has the gold, for example, physically stored in a vault and it serves as the underlying asset for the ETF.
There are other ETFs in this space that will invest in futures contracts on the commodity in question. Oil and gas are examples as these physical commodities are expensive and difficult to store.
When going the ETF route, there are a couple of things to consider:
ETFs trade on the stock exchange. The price is determined by what a buyer is willing to pay for the shares. The share price will be influenced by the underlying commodity, though the price of the ETF will likely not track it.
ETFs and mutual funds have expense ratios that will reduce your net return.
Investors who want more direct exposure to the actual commodities have other options, such as…
Managed Futures Fund
A managed futures fund or commodity pool is similar to a mutual fund in that a number of investors contribute to the pool, with the pool buying and selling the futures contracts on various commodities.
The principal here is that investors will get more leverage by pooling their money together than by individually investing, say, $10,000 each in commodities. When looking for a legitimate commodity pool, it’s important to contact the Commodity Futures Trading Commission if you have any doubts about any pool you may be considering.
Individual futures Trading
Individuals can trade futures directly by opening an account with a broker that supports trading in futures. The broker will ask you a number of questions to ascertain your experience and knowledge as a trader and investor.
Some brokers may allow you to use a virtual “practice” trading account to gain experience in trading futures contracts.
When trading futures contracts, you will want to be sure you understand several issues including:
The unit of measurement of the underlying commodity per each contract. This could be some sort of weight in the case of precious metals, volume-based in the case of oil or gas, and quantity based in the case of agricultural futures.
How the trade will be settled if you were to still hold the contract at the expiration date. (Many futures contracts are settled in cash.)
The quantity of goods based upon the unit of measurement used
The currency in which each contract is denominated and the currency in which the price of the contract is quoted
Grade or quality considerations of the underlying commodity. (For example, the contract might cover oil refined to a certain level.)
It’s very common for brokers offering futures trading to offer generous margin and leverage requirements to traders. Margin accounts mean that the trader can essentially borrow money from their other positions to cover additional transactions.
There is interest to be paid on these loans, and if the value of the position covered by the margin becomes too small, you could be subject to a margin call. This means that you could be required to sell your futures contracts in order to cover the margin balance. This could result in steep losses if the value of the position has eroded. You might also need to come up with additional capital if the amount sold doesn’t cover the margin loan.
The margin levels for trading futures might be 10 or 20:1 which are much higher than margins associated with trading stocks.
When the price of the futures contract goes in the right direction for you, the use of leverage via the margin loan can magnify your gains as you are essentially making a large profit on a relatively small investment. However, when things go the wrong way, the use of margin can also magnify the magnitude of the loss.
Buying physical commodities
This isn’t practical for most types of commodities, but can be for gold, silver and other precious metals. In order to do this, you would need to find a reputable dealer and have a means to securely store the metal. (Storing precious metals at home is a bad idea for many reasons.)
You will need to research dealers to ensure that you are dealing with a reputable dealer. You will also need to research the amount the dealer will charge you, as well as fees for the storage facility.
Additionally, there other issues to consider:
Some states may assess a transaction tax, so be sure you understand the rules for your state.
The quality, mint, and weight, of the gold or silver that you will be buying
Insurance on the gold. Things can happen, including theft. You want to be sure you’re covered.
Valuation. You’ll want an independent valuation of the metal before purchasing
Investing with a Robo-Advisor
Investing in only commodities, or any single asset class alone does not allow for a diversified portfolio. Many people choose to invest with a robo-advisor because it allows for further diversification. This means if one investment goes sour it does not drag down your entire investment portfolio. A robo-advisor can help you determine what your overall asset allocation should based upon you situation. You just take a short survey to determine your goals and risk tolerance before a personalized portfolio is built for you.
Advantages of investing in commodities
One of the biggest advantages to adding commodities to your investment strategy is that they historically have a low correlation to more traditional stock and bond investments. This can help insulate at least a portion of your portfolio from stock market volatility.
Commodities have traditionally been a good hedge against inflation. This is especially true of hard assets like gold and precious metals. The reality is that the quality of this inflation hedge will vary by individual commodity, so if this is an objective, do your homework first before investing.
Risks of commodity investments
Investing in commodities does not provide any sort of regular income like interest or dividends. Prospective investors need to understand this before embarking on an investment in commodities.
Commodities can be quite volatile. Factors such as the weather, a strike, and changes in consumer or business preferences can all influence the price of specific commodities. Commodities can be more difficult for novice investors to understand, and the process is less intuitive than monitoring the price of an individual stock or other more traditional factors.
Commodities can be a great diversifier for your portfolio, but for most investors, overdoing the allocation to commodities is probably not appropriate given the risks and other factors mentioned above. A diversified portfolio that includes a reasonable allocation to commodities is probably the best path for those who want some exposure to this asset class. If you are not comfortable doing this yourself, consider working with a human financial advisor or a robo-advisor to help you determine the best asset allocation for your situation.
If you’re considering investing in commodities look at the alternatives mentioned here. Determine the best approach given your current financial situation, your goals, and your comfort level with investing in an alternative asset like commodities. As with any investment, don’t invest in any financial instrument that you don’t understand.