Why – and how – to invest in commodities

Investing Insights

Commodities investing often conjures the idea of frantic investors in a trading pit, winning and losing fortunes in a blink.

However, you can invest in commodities in more than one form and with more than one product. There are futures contracts, exchange-traded products and mutual funds. You may also simply buy physical raw commodities.

One of the appeals of commodities is the range of products available. You can invest in agriculture, natural resources, precious metals and livestock.

Here are three reasons to consider commodities in your portfolio and five ways you can invest in them.

Why invest in commodities

  • Commodities may minimize portfolio volatility. Weather, politics or global production can affect commodities returns, so the historical correlation of commodities to traditional assets is low. As a result, the returns from commodities may help reduce volatility in a diversified portfolio.
  • Commodities can be a hedge against inflation. Commodity prices often follow inflation and may provide a defense against the impact of rising prices. Read more about the effect of inflation on investments.
  • Commodities can be physical assets. Hard commodities, such as gold, may be considered a store of value. This is especially the case when a base level of demand exists. As demand rises, there may be potential for price increases.

How to invest in commodities

  • Physical ownership. This is the most basic way to invest in commodities. But unless these are small, transportable assets like precious metals, it can be impractical. Imagine storing bales of cotton, steers or barrels of frozen orange juice concentrate. Owning these types of commodities is usually best left to those who will be turning that commodity into a finished product.
  • Futures contracts. Futures originated as a way for farmers to set a price for future delivery of goods. These contracts are perhaps the most well-known method for investing in commodities. While it can be risky, trading in futures can help protect against swings in other parts of your portfolio. Futures contracts have price-mechanism transparency, and you can access a commodity futures contract for a small fraction of its value. Buying and selling futures contracts requires skill and experience. If the forward price, or what you paid for the contract, is higher than the spot price when the contract comes due, you’ll lose money.
  • Individual securities. Shares of commodity-producing companies grant you indirect access to the commodity markets. If the commodity rises in price, the companies producing that commodity may experience increased revenues and profits.
  • Mutual funds, exchange-traded funds (ETFs) and exchange-traded notes (ETNs). These securities can provide you wide exposure with relatively low investment minimums.
  • Alternative investments. Hedge funds or private investments specializing in commodities are an option. These are highly speculative and leveraged investment strategies, carrying a high degree of risk and volatility. Enhanced returns are a possibility, but there is no guarantee of success. It’s a good idea to work with a financial professional before taking this approach.

Common commodities terminology

If you’re thinking about investing in commodities, it’s good to know the terms of the trade. Here are some key terms associated with trading commodities.

  • Commodity: Raw materials and unprocessed goods that are either consumed directly or are processed and resold, such as gold, oil, wheat, cattle and aluminum.
  • Forward price: The agreed-upon price of an asset in a forward contract where prices are set now but delivery and payment will occur at a future date.
  • Futures: An exchange-traded derivative. A future represents an obligation to buy or sell some underlying asset in the future for a specified price.
  • Index performance: Most commodity ETFs/ ETNs and mutual funds track a commodity index like the S&P GSCI. Investors should be aware that indices don’t always track with spot prices of specific commodities.
  • Spot price: The price quoted for immediate payment and delivery of a specific commodity. This price applies only to delivery.

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