Invest in commodities. Diversify your portfolio.
We deal with commodities in our day-to-day lives: when shopping, at the gas station, and when making a call with a mobile phone. But investors can also invest in commodities. To diversify their portfolio, for example. Because commodity price trends correlate little with those of other types of investments.
Four categories of commodities
Hardly anyone would think that they're purchasing commodities when they're in the supermarket or at the gas station. But that's exactly what we're doing when we buy food, gasoline, furniture, electronic devices, or gold jewelry.
Commodities are divided into two general categories: hard and soft commodities. The second category includes all agricultural products such as corn, cocoa beans or cotton. Precious metals such as gold and silver are traded as hard commodities, as well as industrial metals like aluminum and copper, and commodities from the energy sector such as natural gas and coal.
Commodities are traded on futures markets
The price at which a commodity is traded depends on the supply of and demand for the product in question. But contracts for purchasing commodities are often made for the future, by means of futures on forward markets. Farmers, for example, sell their future harvest in advance so that they know how much they will earn from it. This is an important hedging transaction for them. The buyers bear the risk.
In concrete terms, buyers purchase an agreed quantity of a product at a fixed price on or before a specific date in the future. If this price for future contracts is higher than the current spot rate, this is referred to as contango (see info box). The forward rate depends to a large extent on what is known as the convenience yield, and any storage and financing costs. Or, in concrete terms, imagine having to erect oil tanks in your garden for storage purposes. This would require a significant investment in infrastructure, space, and maintenance.
Investing in commodities as a private investor
Private investors can trade in commodities in different ways:
- Commodity funds and commodity ETFs: For private investors, the easiest way to invest in commodities is to purchase units in corresponding funds or ETFs. These include funds that have an active trading strategy. Mostly, however, commodity funds replicate a commodity index.
- Physical purchase of commodities: Gold and other precious metals can, in principle, be physically purchased and stored in the vaults of banks. With other commodities, this is more difficult, and you'd need to have an oil tank or grain silo in your garden.
- Stocks of commodity companies: Private investors can also invest in commodity companies just as they would invest in other companies. The disadvantage, however, is that they only participate indirectly in commodities trading, and do not share directly in commodity price trends. Because the stocks of commodity companies correlate more closely with other investments than with commodity prices.
- Forward transactions: Like professional investors, private investors can also trade in commodities using forward transactions. This demands experience. The prices of such forward transactions depend on various factors. Availability in particular plays an important role, for example, the output of oil, as do the storage costs of commodities.
Investing in commodities: Opportunities and risks
In the long term, the demand for commodities rises alongside global population growth. At the same time, the natural resources of certain commodities are in short supply, which impacts prices and therefore offers opportunities for investors. Investors can also use commodities to hedge against inflation, because, while cash loses value due to inflation, the value of commodities climbs at the same time. The most important argument in favor of commodity investments, however, is risk hedging. The return drivers of commodity investments are different than those of equities or bonds, for example. Therefore, it can be worth adding commodity investments to a portfolio in order to diversify it.
Commodity investments can be very volatile, however. This makes it even more important to be aware of the risks of each investment and, for example, to only invest in forward transactions if you understand their mechanisms exactly. Also when investing in commodity ETFs or funds, investors must look closely at the risks, such as the weighting of the different commodities and how they correlate with each other. Investing in various commodity investments can reduce the risk.
Investing responsibly in commodities
Commodity investments have fallen into disrepute in recent years. The trade in agricultural products is particularly frowned upon. But commodities can supplement an investment portfolio if they are carefully selected, in particular if environmental and social factors are taken into account. For example, investors buying the stocks of commodity companies can focus on sustainability, be it by investing in ecological agriculture, in the recycling of electronic waste, or in the area of sustainable fashion. By making investments of this kind, investors set an example at the same time as driving sustainability forward.
Especially among millennials, many people are focusing on sustainability, both as consumers and investors. This is why sustainable investments have potential for above-average growth and excess returns. This is something that financial institutions have also recognized. For example, the first sustainable commodity funds have recently become available from banks. So for people who take time to check commodity investments, it is entirely possible to invest responsibly in commodities.