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Commodities are raw materials used for manufacturing the goods that individuals and corporations consume and use every day. Raw materials are used to produce just about everything, including staples and heavy machinery.
In today’s globalized market, commodities have been securitized to facilitate trading and pricing. Retail investors can now incorporate this interesting asset class into their portfolios by using multiple vehicles such as exchange-traded funds (ETFs) and futures.
However, since commodities are much less advertised than other traditional asset classes such as stocks and bonds, investors tend not to consider them feasible alternatives for the further diversification of their portfolios.
Therefore, we came up with this guide on how to invest in commodities so you can understand the kind of items you can invest in, which vehicles you can use to get exposure to them, and what to look for when selecting the best instrument for your portfolio.
How Do Commodities Work?
The first thing you should understand about commodities is that they come in many shapes and forms as there are dozens of different materials that are regularly traded in the global financial markets, including soybeans and crude oil.
To simplify the market for you, here’s an overview of the most common types of commodities you can invest and trade nowadays:
|Non-Renewable Energy||Hard commodity||Crude oil, natural gas, nuclear, coal, uranium, propane|
|Renewable Energy||Hard commodity||Solar, wind, water, biomass, geothermic, fuel cells, hydropower, ethanol|
|Precious Metals||Hard commodity||Gold, silver, platinum, palladium|
|Base Metals||Hard commodity||Aluminum, copper, lead, nickel, zinc|
|Ferrous Metals||Hard commodity||Iron, steel|
|Food (Wheat)||Soft commodity||Corn, rice, barley|
|Food (Oilseeds)||Soft commodity||Soybeans, palm oil|
|Food (Semi-luxury)||Soft commodity||Coffee, cacao, tea, tobacco, sugar, orange juice|
|Industrial Agro Materials||Soft commodity||Cotton, wool, timber, rubber|
|Livestock||Soft commodity||Feeder cattle, live cattle, lean hogs, pork bellies|
Agricultural & Soft Commodities
Agricultural commodities, also known as soft commodities, are those that are obtained and commercialized directly as they come out of the ground — quite literally. This includes wheat, soybeans, cocoa, sugar, barley, corn, and oats.
That said, there’s a slight difference between agricultural and soft commodities. The former requires no industrial process before shipping while soft commodities are often sold after they have been processed into a more standardized form, as is the case with sugar and lumber.
Energy commodities are grouped into two segments: renewable and non-renewable. Non-renewable commodities are oil, natural gas, coal, propane, and others. Global reserves of these commodities are limited and cannot be replenished on short notice.
Renewable energy sources include energy produced by solar panels, wind, hydrogen-processing plants, and ethanol-processing facilities.
A livestock commodity is associated with a specific part of an animal that is commercialized on the global market. This includes live and feeder cattle, pork bellies, and many others.
Metals have their own sub-segment in the commodities market as they are often known as hard commodities. Meanwhile, there’s a sub-segment of this type of commodity that refers specifically to precious metals such as gold, platinum, silver, and palladium.
The other sub-segment of hard commodities is industrial-use metals, such as steel, iron ore, and copper, which are more commonly used by companies around the world to manufacture products for multiple purposes.
Which Commodity Should You Invest In?
As you can see, the commodities market is quite ample and this makes it a fairly complex market to understand, which is why investors should do their fair share of due diligence about the variables that influence the price of each of these items since the same environment that could be positive for gold might not be equally positive for crude oil.
As a rule of thumb, the most popular commodities among retail investors include gold, silver, oil, natural gas, and copper. This does not mean that retail investors can’t or won’t trade other less popular commodities such as live cattle and sugar but they tend to be less popular than the above-mentioned items.
Ways to Invest in Commodities
Even though there are dozens of commodities that investors can incorporate into their portfolios, there are only a handful of vehicles through which you can invest in them and, in the following section, we will explain how most of the vehicles that are offered by brokerage firms nowadays work.
> Purest form to invest in commodities
> Intrinsic value
> Physical ownership
> High transaction costs (i.e. purchase, shipping, transport, etc.)
> High cost of storage limit volume
|Options and futures||
> Investment without the need of storage
> Portfolio diversification
> Inflation hedge
> Frequent and complex transactions
> Risk of contango
> Extremely liquid
> Tradable through a brokerage account
> No storage or transaction limitations
> Performance depend on a company's valuation
> Indirectly invested in commodities
> Not available for all commodities
Futures contracts are among the most popular vehicles through which investors can get exposure to the different commodities traded in the global financial market.
A futures contract gives the holder both the right and obligation to buy or sell a certain volume of an individual commodity at a certain date at a predefined price. Futures contracts were primarily designed to help companies in securing a price for the raw materials they need for their businesses while producers could also secure the price at which they would be paid for the goods they have harvested, extracted, mined, or whatever else.
However, investors can speculate on commodities by using futures contracts. The term speculation refers to the fact that the price of these items is considered quite volatile when compared to other asset classes.
That said, a thorough analysis of the dynamics that dominate the price of a certain commodity could result in the development of sound criteria for investing in a certain commodity, possibly as much as a financial model would provide an objective assessment of the value of a company.
A futures contract usually has a monthly expiration date and, once that date is reached, the person holding the contract must take delivery of the goods. In the case of oil, for example, the futures contract offered by the CME Group entitles the holder to receive 1,000 barrels of crude oil.
The price per barrel will be determined by the price paid per contract while investors can always sell the contract before it expires to roll their position over to next month’s contract and avoid having to take delivery of the commodity.
There are a few risks involved when investing in commodities by using futures. One of those is rollover risk, which refers to the possibility that the price of next month’s contract will be higher than the price paid for last month’s contract — a situation that would result in a rollover loss. Other risks include liquidity and exercise risks.
An options contract works similarly to a futures contract. However, the main difference between them is that an options contract gives the holder the right, not the obligation, to exercise the contract once it expires.
This means that an options contract could expire worthless if its strike price is below the price of the underlying asset (call option) or above-said price (put option).
A call option gives the holder the right, not the obligation, to buy the underlying asset at the strike price while a put option gives the holder the right, not the obligation, to sell the contract at the strike price.
Options contracts can be traded at multiples of 100 contracts and the investor will pay a premium on each contract that is determined based on the current level of volatility in the markets and other technical factors.
Once the options contract expires, the holder will have the alternative to take delivery of the underlying asset, which in this case is a certain commodity. Unlike with futures, the holder of an option will have to buy or sell the underlying asset at the strike price if he/she decides to exercise the contract.
Same as with futures, for a retail investor, an options contract will have to be rolled over before expiration to avoid having to take delivery of the underlying asset. Meanwhile, the same risks that apply to futures contracts apply to options, as well, as investors might face rollover risks under many different circumstances.
Pro Tip: Options contracts can provide investors with many advantages like risk-reduction strategies, cost-efficient way to long or short equities and a way to profit under any market scenerio.
Physical ownership of a commodity is another way to expose your portfolio to this market. You could, for example, buy gold or silver by bullion or you could also buy jewelry. The same applies to most precious metals.
In the case of precious metals, there are certain providers, like Bullion Vault, that allow you to invest a certain amount in gold or silver while they take care of storing the items safely and charge you a fee for their services.
It might not be convenient to invest in commodities like sugar, wheat, iron ore, or copper directly as that would generate significant storage costs along with many risks, including damage and theft.
Mutual funds are a financial vehicle through which investors can get exposure to a single commodity or to the market as a whole as some of these funds track the value of an index composed of a basket of different commodities.
One example of this is the Gabelli Gold Fund Class A (MUTF: GLDAX), which invests in both gold and gold mining stocks. To date, this fund manages a total of $437 million for investors and charges a 1.5% annual expense ratio. Meanwhile, a minimum of $2,500 investment is required and investors must pay a 5.75% load to invest in precious metals through this vehicle.
Another mutual fund offering exposure to a diversified basket of commodities is Credit Suisse Commodity Return Strategy Fund Class A (MUTF: CRSAX) mutual fund, which tracks the Bloomberg Commodity Index Total Return. This fund has an expense ratio of 1.03% and charges a 4.75% load. The minimum investment for this fund is $2,500 as well.
Mutual funds tend to be less popular among retail investors compared to exchange-traded funds (ETF) due to their higher expense ratios, minimum investment required, and load fees.
Exchange-Traded Funds (ETFs)
The benefit of ETFs compared to mutual funds is that they can be easily traded through an exchange while these vehicles tend to charge lower expense ratios and no-load fees. Additionally, the minimum investment required is the cost of one share of the ETF, or, in some cases, your broker might even allow you to buy a portion of a single share of an ETF via fractional shares.
Among the most popular commodity ETFs, we find the Invesco DB Commodity Index Tracking Fund (NYSEARCA: DBC), which currently oversees $2.7 billion from investors while charging a 0.88% annual expense ratio. This fund invests in a wide range of commodities to offer investors exposure to the entire market.
Meanwhile, certain commodity-specific ETFs include the United States Oil ETF (NYSEARCA: USO), which offers exposure to crude oil via futures of the West Texas Intermediate (WTI), and the SPDR Gold Trust (NYSEARCA: GLD), which offers exposure to gold.
The term commodity stock refers to an equity instrument that offers exposure to the price of a commodity indirectly as the underlying business extracts, exploits, commercializes, or deals in some way with such an item. One example is companies that mine precious metals or explore and drill oil wells.
The price of these stocks tends to be highly correlated with the price of the commodities they deal with and investors can either purchase individual stocks of companies they believe will perform well over time or they could also get exposure to a diversified basket of these stocks by buying a sector-specific ETF.
One example of this is the VanEck Vectors Gold Miners ETF (NYSEARCA: GDX), which offers exposure to companies that mine this particular precious metal or the SPDR Energy Select Sector ETF (NYSEARCA: XLE), which invests in companies within this specific segment of the economy including those that drill and commercialize oil, natural gas, and other similar commodities.
Pro Tip: Commodity stocks allow investors to get exposure to commodities by buying shares of companies that produce them.
Alternative investments have been gaining popularity as they offer exposure to certain specific opportunities in the commodity markets via structured deals, private placements, and debt offerings.
An investor could get exposure, for example, to the oil market by investing in a project that involves exploring, drilling, and selling oil. On the other hand, certain companies also offer exposure to debt offerings from businesses that primarily deal with commodities, such as a bond offering from a gold mining company.
Although these investments might offer a higher return than the more traditional instruments mentioned in this list, they also carry a higher risk and demand much more in-depth knowledge of the market, company, and instrument to make sure that the proposed benefits outweigh the risks.
Benefits of Investing in Commodities (Pros)
- They help investors in further diversifying their portfolios while providing the potential to enhance returns in the long run.
- Certain commodities, such as precious metals like gold and silver, could provide hedging opportunities in inflationary or recessionary environments.
- Commodities are physical assets that can be easily bought and sold as the market for them is huge in terms of daily trading volume and demand.
Downsides of Investing in Commodities (Cons)
- The cost of investing in commodities tends to be higher compared to other financial assets unless investors use the cheapest vehicle of all, which are ETFs at the moment.
- The commodities market is considered highly volatile compared to the equities market due to the inherent volatility of the variables that dominate the price of these items. For example, oil prices could fluctuate widely — even to negative territory — as investors witnessed during the pandemic.
- Establishing the fair value of a certain commodity can be a very complex and time-consuming task. For this reason, investors should seek advice before incorporating an individual commodity or even an ETF tracking the entire market.
FAQs: How to Invest in Commodities?
We have probably covered most of what you need to know about the vehicles that are currently available for investing in commodities. However, if you still have doubts about how they work or whether you should consider incorporating them into your portfolio, the following is a selection of the most frequently asked questions we get on this particular topic.
Why Invest in Commodities?
Commodities are risky and volatile, yes. However, in the long term, certain studies have shown that their contribution to a portfolio’s return is remarkably positive during periods of high inflation.
What Is the Best Way to Invest in Commodities?
Exchange-traded funds (ETF) are without doubt one of the best vehicles for investing in commodities due to the high level of liquidity that these instruments have and the low expense ratios that funds charge to investors. Additionally, ETFs eliminate the natural storage costs and the inherent risks resulting from holding physical assets (i.e., theft, damage, etc.)
How Do Beginners Invest in Commodities?
For beginner investors, the commodity market might not be the best place to start to get to know how financial markets work due to the complexity of the variables that influence the price action of these assets.
In most cases, it would be a good idea to seek advice about whether it would be positive to incorporate a certain commodity or basket of commodities into your portfolio or not.
How Do I Buy Commodities?
You can buy commodities through any of the vehicles listed above. Nowadays, most online brokers offer access to exchange-traded funds (ETF) and commodity stocks. On the other hand, to buy futures and options contracts for commodities, the selection of brokerage firms offering access to these instruments is probably smaller and you should take a look at our list of preferred brokers to check which of them currently offer that possibility.
What Is the Best Commodity ETF?
If you are looking to invest in the commodity market as a whole, the best alternatives out there include the iShares S&P GSCI Commodity-Indexed Trust (NYSEARCA: GSG), which invests in many types of commodities — although it is primarily exposed to the energy sector. This fund charges an annual expense ratio of 0.85% and manages over $1 billion in assets for investors at the moment.
Another option would be Invesco’s DB Commodity Index Tracking Fund (NYSEARCA: DBC), which seeks to provide exposure to a broadly diversified basket of commodities, currently charging a 0.88% annual expense ratio while overseeing over $2 billion in assets for investors.
Meanwhile, for commodity-specific investments, the SPDR Gold Trust (NYSEARCA: GLD), the United States Oil Fund (NYSEARCA: USO), and the iShares Silver Trust (NYSEARCA: SLV) are among the most popular funds among retail investors due to their low expense ratios.
Why Is It Risky to Invest in Commodities?
The price of commodities tends to fluctuate wildly and they are influenced by a wide range of variables including the overall state of the global economy, climate, geopolitical developments, and traditional supply and demand dynamics.
Given the complexity required to determine the fair value of a commodity in the context of a globalized economy, the task of foretelling the direction that the price of a single commodity might take is quite overwhelming for non-professional investors.
Now that you know how to invest in commodities and the benefits and risks of doing so, you should start by analyzing the current state of the global economy to determine if this is a good time to step into this interesting market.
Keep in mind that, for most investors, incorporating commodities into a portfolio can increase its volatility and, therefore, you should make sure you put a cap on the percentage that you will allocate to this asset class unless you are prepared to experience a wild ride.
Additionally, commodities tend to generate better results over long holding periods, which is a good reason to consider buying and holding instead of trading these instruments based on temporary market fluctuations.
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Alejandro is a financial writer with 7 years of experience in financial management and financial analysis. He writes technical content about economics, finance, investments, and real estate and has also assisted financial businesses in building their digital marketing strategy. His favorite topics are value investing and financial analysis.