One of the words you’ll hear most when talking with experts about investing in commodities is “hedging.”
First, commodities, or agricultural products and raw materials that can be easily bought and sold, tend to have a low correlation to stocks and bonds. That means they offer a hedge against downturns in those bigger asset classes.
Also, commodities have been historically viewed as a hedge against inflation because rising consumer prices are often linked to rising commodity prices.
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Commodities are also notoriously volatile, as they ride the ups and downs of the global economy. And gauging when prices might rise can be challenging, as commodities prices are governed by global supply and demand issues.
For most investors with a long time horizon, a strategy of dollar-cost averaging into low-fee equity index funds is the most prudent, says Robert Johnson, finance professor at Creighton University.
“Commodity-focused exchange-traded funds, exchange-traded notes and mutual funds are probably among the simplest ways for investors to gain exposure to various commodities without directly owning the physical assets.” – Michael Ashley Schulman, chief investment officer, Running Point Capital
But for those who do want to try to capture the advantages of investing in commodities as a hedge, a rule of thumb is to allocate only about 5% of your portfolio to these raw materials and agricultural products. Here’s what to think about if you’re trying to fill that bucket:
— Types of commodities.
— Commodities as an inflation hedge.
— Commodities as a diversifier.
— 3 ways to invest in commodities.
Types of Commodities
Investors often think about two broad categories of commodities.
Hard commodities are natural resources, such as metals like gold, copper and iron ore, and energy products like natural gas, oil and coal.
Meanwhile, soft commodities are grown or ranched, such as pork bellies, cattle, orange juice, corn, wheat and soybeans.
“Oil and industrial metals tend to be the most economically cyclical and agriculture the most weather dependent,” says Michael Ashley Schulman, chief investment officer with Running Point Capital, a multifamily wealth management firm in Southern California. “Nonetheless, agriculture does have some economic variability, and oil and mining production can be shut down by … windstorms, floods or fires.”
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Commodities as an Inflation Hedge
The benchmark S&P GSCI commodities index is down about 8% so far this year as of late May, which isn’t too surprising given that the inflation rate has been easing as well.
That’s right, commodities tend to move with inflation and rising interest rates, instead of inversely like stocks and bonds do.
“Commodities, as a whole, tend to perform better in a rising-rate environment than in a falling-rate environment. In particular, energy and industrial metals commodities have historically performed much better when rates are rising than when they are falling.” – Jim Wiederhold, director of commodities and real assets, S&P Dow Jones Indices
“Commodities are generally good inflation hedges because they tend to move with changes in inflation to the upside and, most recently, to the downside,” Jim Wiederhold, director of commodities and real assets with S&P Dow Jones Indices, wrote in a recent blog post.
Which commodities investors should consider depends on their outlook for interest rates in the upcoming months and years, Johnson says.
“Commodities, as a whole, tend to perform better in a rising-rate environment than in a falling-rate environment,” he says. “In particular, energy and industrial metals commodities have historically performed much better when rates are rising than when they are falling.”
Commodities as a Diversifier
Commodities’ relationship with inflation is one reason why they perform differently than stocks and bonds. Those financial assets tend to do better when inflation is stable or slowing.
As interest rates rise, as they have been recently, bond prices decline as they become less attractive on the secondary market.
Commodities can perform better than stocks in inflationary times because companies can only pass along so many price increases to customers. And the rising interest rates that often accompany inflation make it more expensive for companies to borrow money.
“Because commodities are ‘real assets,’ they tend to react to changing economic fundamentals in different ways than stocks and bonds, which are ‘financial assets,'” according to investment management firm Pimco. “Commodities’ low correlation to stocks and bonds illustrates what may be the most significant benefit of broad exposure to commodities: diversification.”
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3 Ways to Invest in Commodities
With the exception of gold, investors probably don’t want to buy physical commodities in larger amounts than the coffee, cocoa and sugar packages they can buy at the grocery store.
While storage, transportation and maintenance of these goods on a larger scale are impractical for most individual investors, there are other vehicles that offer easier ways to access the commodity market, such as commodity funds, stocks and futures.
Commodity Funds
“Commodity-focused exchange-traded funds, exchange-traded notes and mutual funds are probably amongst the simplest ways for investors to gain exposure to various commodities without directly owning the physical assets,” Schulman says.
These types of investment vehicles can offer single-ticker diversification among types of commodities or holdings of multiple production companies to minimize risk. They can also offer exposure to physical commodities without having to take delivery of the materials.
Schulman cautions that along with commodity risk, ETNs carry the credit risk of the financial institution that issued them.
Some well-known commodity ETFs include Abrdn Bloomberg All Commodity Longer Dated Strategy K-1 Free ETF (ticker: BCD) for diversified commodities, SPDR Gold Shares (GLD) for the precious metal and United States Oil Fund LP (USO) for black gold.
Commodity Stocks
Another way to gain exposure to commodities is by purchasing shares of the companies that produce them.
But keep in mind that investing in producers such as miners or oil companies carries not only the commodity risk but also risks inherent to any company, such as poor management decisions, labor disputes or project cost overruns.
Some popular commodity stocks include Rio Tinto Group (RIO) for mined metals, Cheniere Energy Inc. (LNG) for natural gas or Marathon Petroleum Corp. (MPC) for petroleum refining.
Futures Contracts
Commodities futures contracts are agreements to buy and sell commodities at a predetermined price at some time in the future.
But they aren’t for the faint of heart.
Futures trading involves speculation and requires knowledge of the particular commodity, so it may not be a suitable strategy for a beginner investor. Most participants in the futures markets are institutional producers and consumers.
“If investors want to attempt to beat the market and earn rates of return that exceed that of a simple index of commodities, they may look to the services of a commodity trading advisor,” Johnson says.
These professional money managers who focus on commodities can provide individualized advice and put together a portfolio of futures contracts on behalf of the investor.
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How to Invest in Commodities originally appeared on usnews.com
Update 05/25/23: This story was previously published at an earlier date and has been updated with new information.
