Investing in Commodities: A Primer
Commodities are raw, interchangeable materials, that can be consumed directly, or used as building blocks to create other goods and products.
Commodities can be categorized into two major groups: soft commodities and hard commodities. Soft commodities consist of animal and plant-based products like corn, soybeans, live cattle, and lumber. Hard commodities, on the other hand, include energy-related products like crude oil and natural gas, and metals like gold, silver, and copper.
Investors commonly start investing in commodities to introduce more diversification into their portfolio, potentially hedge against inflation, or to speculate on specific market themes. Other market participants invest in commodities because they are a commodity producer or consumer and are attempting to hedge their business’ exposure to the risk of a price change in commodities.
Retail Investors generally invest in commodities through physical ownership, or an exchange traded fund/note (ETF/ETN) or mutual fund. The most direct way to start investing in commodities is physical ownership, for example, going out and buying gold or silver coins. But as you can imagine, for commodities like crude oil or cattle this can pose some challenges. Sometimes to gain exposure to commodities, investors will opt to invest in the stock of a commodity-related company, like a gold miner. While this is not a “pure play”, some investable companies do exist that are highly correlated to the underlying commodity that they produce, process, or extract. These securities-based approaches can be a good option for some investors who do not want to worry about the challenges that come along with physical ownership and storage.
Commodity Producers or Consumers are active participants within the commodities markets. It may seem odd that commodity producers are also investing in commodities, but they will often buy or sell futures contracts on commodities to hedge their businesses against large moves in commodity prices. A futures contract is a contract in which an investor promises to buy or sell a particular commodity at an agreed-upon price on an agreed-upon date. Through a futures contract, a farmer can lock in the price at which they will sell corn in the future. This allows the farmer to have a clearer understanding of their future revenue and budget more appropriately. Futures are also used by other investors like investment managers and hedge funds but were originally used by commodity producers.
Hedge Funds will invest in commodities as part of a specific strategy, called Managed Futures or Commodity Trading Advisors (CTAs). A CTA is an individual or organization that, for compensation or profit, advises others, directly or indirectly, as to the value of or the advisability of trading futures contracts, options on futures, retail off-exchange forex contracts or swaps. In the hedge fund context, some hedge funds acting as a CTA will buy and sell commodities based on a variety of quantitative or trend-following trading strategies. Hedge Funds will also invest in commodities to speculate on specific market themes. For example, a hedge fund might believe that there will be more new construction than the market anticipates. Based on that view they might decide to purchase copper, as copper piping is a key construction resource. If the manager’s thesis is correct, copper prices may appreciate and the manager’s trade could be successful, or vice-versa.
While investing in commodities may not be suitable for all investors, there are some general reasons that they are included within the asset allocation of many individual and institutional investors. We list three key potential benefits below.
Diversification - Investing in commodities can decrease your portfolios correlation to major asset classes like equities and bonds. Some commodities have produced positive returns during times of market stress and have helped prevent extreme drawdowns within portfolios.
Potential Inflation hedge - History has shown commodity prices are positively correlated with inflation. Investing in commodities to hedge a portfolio against inflation is very common. While this relationship sometimes does not hold in the short term, over a longer period, investing in commodities has proven to be an effective inflation hedge.
Potential for Alpha - There are hedge funds and investment managers that have shown that they can generate excess returns, or alpha, over time through investing in commodities. While this past performance cannot be guaranteed to persist in the future, sourcing a quality managed futures or CTA fund could provide alpha for investors.
It is important to consider some of the specific risks that come up when investing in commodities. In the next section we will list and discuss some of these risks.
Below, we explain some of the risks associated with investing in commodities. It is worth noting that this list is not exhaustive, but rather focuses on risks you may come across more frequently when investing in commodities.
- Principal or Volatility Risks - Commodities can be highly volatile and subject to large swings in price especially if the investor is not investing in a diversified basket of commodities through an ETF, mutual fund or hedge fund.
- Uncontrollable Macro Risks - Commodities can be subject to macro risks such as unforeseen government regulations, extreme weather, or geopolitical events. There are many other macro risks, and while all securities are exposed to them, commodities may be more sensitive to some.
- Basis Risk - This is the risk that the relationship between a commodity and a security which tracks that commodity will not hold under certain circumstances. Basis risk can impact the effectiveness of a hedge and is particularly prevalent in the futures market.
- Key Person or Team Risk - If investing in commodities through an investment manager or hedge fund, there is a risk that the team or portfolio manager with expertise in commodities, will leave the firm. If this person or team was responsible for making decisions that led to excess returns then their departure could lead to poor fund performance.
- Liquidity Risk - Commodities are traded like other securities, that is, they require that there be a buyer and seller. If there are not sufficient counterparties you may not be able to sell a particular commodity. This risk is higher during times of market stress when there may be more investors selling than there are buyers.
Commodities and futures contracts serve important roles in the U.S. and the world’s economy and investing in commodities can be a powerful tool within an investor’s toolbox. The ways investors introduce commodities into their portfolio range significantly. While there are certainly risks to investing in commodities, it remains a popular asset class for individuals, corporate investors, and hedge funds alike.
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