Investors who diversify their portfolios typically strengthen their investment goals by maximizing returns while reducing risk. Many choose stocks, bonds, commodity-centric mutual funds, futures, and currencies, but investors can add commodities. These are basic goods that can be transformed into other goods and services.
Key Takeaways
- Investing in commodities can provide investors with diversification.
- Supply, demand, and geopolitics all affect commodity prices.
- Investors can trade commodity-based futures, stocks, ETFs, or mutual funds or hold physical commodities such as gold bullion.
What Is Commodity Investing?
Commodity trading historically linked cultures and people. From spices and silks in the early days to the exchanges where these assets are now traded, commodities are still popular investment vehicles. Commodity-hungry investors can consider investing directly in the physical commodity or indirectly by purchasing shares in commodity companies. These companies are accessible through several mutual funds or exchange-traded funds (ETFs).
Investing in commodities tends to protect investors against the effects of inflation. Generally, demand is high during periods of inflation. Commodities are also a good bet against the U.S. dollar. When the greenback declines, commodity prices rise.
Investors can maximize returns with commodity investing due to strong global demand. However, commodities tend to be more volatile than other investments, especially funds that track a single commodity or a specific sector of the economy. Investors who trade futures should remember that it involves speculation. Futures contracts track an underlying commodity or index. Futures have unique risks that must be managed independently of the underlying commodity.
Cons
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Increased volatility when compared to other investments
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Margin trading in commodities potentially resulting in significant losses
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Speculative nature of trading with uncertainty of the outcome
Crude Oil
After production, crude oil is refined into products like gasoline. However, petroleum products include plastics, medicines, floor wax, shingles, ink, cosmetics, synthetic fibers, solvents, fertilizer, and asphalt. Crude oil generally reacts to the laws of supply and demand. When demand exceeds supply, prices tend to rise. When demand wanes, prices tend to fall.
Similarly, demand from developing nations such as China and India—whose economies are still growing—pushes up prices. Geopolitics impacts the price of crude oil. Tensions in the Middle East, where much of the world’s oil is produced, can increase oil prices.
Oil futures are a favorite of day traders and are bought and sold through brokerages. However, futures can be highly volatile and require capital. Investors may consider purchasing stocks in oil companies, crude oil mutual funds, or ETFs. Other options include buying shares in energy sector mutual funds or ETFs, which invest directly in oil company stocks. The U.S. Oil Fund is one example. It tracks the movement of West Texas Intermediate light, sweet crude oil.
Important
Gold
Gold is found in jewelry and technology and used by central banks and investors. This precious metal has traditionally been a safe investment and a hedge against inflation. When the U.S. dollar goes down, gold prices go up. Prices are affected when central banks—which hold gold—decide to diversify their monetary reserves by buying more gold.
Unlike crude oil, investors can hold the physical commodity. Investors can purchase gold bullion bars or coins. But this means having to pay to store it in a deposit box, vault, or safe place. Gold futures contracts require investors to deposit an initial margin. If the price rises, investors will profit; however, if the price drops, the investor stands to lose their money.
With gold stocks, investors aren’t limited to producers but also exploration and mining companies. Gold ETFs track the price. For instance, the SPDR Gold Shares ETF exposes investors to bullion without having to take possession of it.
Base Metals
Base metals are used in commercial and industrial applications, such as construction and manufacturing. Aluminum, zinc, and copper are examples. They are relatively inexpensive, and supplies are generally stable because they’re commonly found globally.
Prices tend to be much lower than for precious metals; however, the increase in base metal applications and rising global demand—particularly from China and other developing nations—positively impact prices.
Investors can hold stocks in base metals firms like aluminum or steel companies. Furthermore, holding ETFs like the SPDR S&P Metals & Mining ETF provides exposure to companies involved in metals and mining.
Are ETFs a Good Investment Vehicle for Commodities?
Commodity ETFs allow for easy trading because they are purchased like stocks, provide diversification, are not traded on margin like futures are, and typically have low expense ratios.
When Should Investors Buy Commodities?
Commodities are a hedge against inflation, so buying before periods of high inflation is a common investment strategy. Commodities should be viewed as any other investment concerning an investor’s time horizon and risk profile.
What Are Common Base Metals?
Base metals are nonferrous metals that are not considered precious or noble metals. The most common base metals are copper, lead, nickel, tin, aluminum, and zinc.
The Bottom Line
Like any investment, commodities come with risks but can still be a way to diversify an investor’s portfolio. In addition to oil, gold, and base metals, other commodities to consider are platinum, palladium, silver—lithium, cotton, and food products such as coffee, corn, oats, wheat, soybeans, and sugar.