Move over, Bitcoin. There is a new and exciting trade in the city: commodities.
Brazil’s drought is driving double-digit gains in coffee futures and threatening the price of everyone’s daily caffeine fix. And it’s not just coffee, as vaccine-driven global growth has seen prices for many commodities — sugar, oil, gold, and more — undergo a broad rally that has left the sector red-hot.
The Invesco DB Commodity Index Tracking Fund, which aims to achieve diversified exposure to commodities, is up 56% in the past year alone.
And the strong performance in commodities is attracting the attention of retail investors looking to take action.
But before you jump in first, it’s important to at least know the basics. Commodity trading is a different beast than stocks, with a unique risk versus reward profile, so an extra layer of due diligence is required.
What is investing in commodities?
Raw materials are the raw materials that form the basis of everyday life: things that can be mined, drilled or cultivated and then used to produce the goods we use.
Whether we drink coffee, put on a new T-shirt or pump petrol into our cars, raw materials make it all possible. This means that people’s daily consumption habits have a significant impact on commodity prices.
From an investor’s perspective, trading commodities is simply buying and selling these commodities to make a profit or hedge risk.
There are four main types of goods:
Agricultural products: These soft commodities are grown and include products such as cocoa, coffee, cotton, sugar, corn, wheat and fruit.
Livestock and meat: Soft commodities that are bred and include products such as live cattle, chickens, pork belly and milk.
Energy products: Hard resources that are drilled or mined and include things like oil, coal, natural gas, ethanol and electricity.
metal: Hard commodities that are mined and contain both precious metals (such as gold and silver) and base metals (such as copper, aluminum and zinc).
Why invest in commodities?
While investors are always looking for greater returns, there are other good reasons to invest in commodities:
Reason No. 1: Diversification
Diversification is probably the best reason to add commodities to your portfolio.
Why? Because commodities tend to have little correlation with more traditional asset classes.
Historical trading patterns have shown that stocks and bonds tend to move together. That can make it difficult to arm yourself against a downturn if those are the only groups you invest in.
Commodities are primarily influenced by the dynamics of supply and demand in their individual markets. Variations in demand for oil or copper or cotton will often have a greater impact on their prices than an overall market direction.
That means commodities don’t necessarily keep up with other financial assets; and in many cases they can move in the opposite direction of stocks and bonds.
Allocating part of your portfolio to commodities can therefore protect you against a decline on Wall Street.
Reason #2: Inflation Hedge
Investing in commodities remains one of the most reliable ways to protect from the ravages of inflation. This is because as inflation rises, the price of commodities rises with it.
Legendary investor Warren Buffett recently touched upon this phenomenon when discussing his company’s current housing business.
“The costs are only going up, up, up,” he said at Berkshire Hathaway’s annual shareholder meeting. “Steel costs, you know, they just go up every day.”
Commodities have historically performed well during periods of high inflation, even when stocks and bonds fell.
How to invest in commodities
There are several ways to invest in commodities, including simply buying and owning them directly.
For example, if you want to invest in gold, buying a few gold coins from a local dealer is easy enough.
The difficulty lies in owning unmanageable goods such as natural gas or livestock. Few people have the space to store hundreds of barrels of oil or to house a herd of cattle.
Fortunately, there are three practical methods for average investors to invest in commodities.
Exchange traded commodities funds (ETFs) provide the easiest way to gain exposure without having to own the commodity directly.
Some commodity ETFs allow you to focus on a single commodity, while others group them together for broad exposure.
For example, the SPDR Gold Shares ETF is designed to keep pace with gold prices, giving you a “pure” way to invest in the yellow metal.
Meanwhile, Invesco’s aforementioned Commodity Index Tracking Fund provides exposure to 14 of the most traded physical commodities, including crude oil, gasoline, corn, gold and soybeans.
ETFs typically have very low management fees, and you can save even more by buying them through a No commission investment app.
Another easy way to invest in commodities is to own the companies that produce them.
For example, energy blue chips like BP, Exxon Mobil and Chevron are a good way to gain exposure to oil and natural gas. Agricultural stocks like Mosaic and Tyson Foods allow you to invest in fertilizers and livestock, respectively. Mining giants such as BHP, Rio Tinto and Vale all offer access to a wide variety of metals.
And thanks to a new investment platform, you can actually buy stocks in US farms. You get a discount on both leasing costs and crop sales, giving you cash income as the asset’s value increases.
A word of caution: Commodity stocks don’t always track their underlying commodities perfectly because other company-specific factors come into play, such as the company’s financials, management team quality and long-term production prospects.
At any given time, any of these factors could have a greater impact on the stock price than the underlying commodity.
As with ETFs, you can easily invest in commodity stocks through any number of investment apps, although a few will give you a free stock just for signing up.
Finally, investors can use futures contracts to bet on how the price of a particular commodity will move. Futures involve agreeing to buy or sell a particular commodity at a predetermined price and time in the future.
Buyers of futures contracts benefit when commodity prices rise. Sellers of futures contracts benefit when commodity prices fall.
While futures are designed for major commodity producers to hedge against price volatility, individual investors can participate in the game if they have a brokerage account that offers it.
Novice investors should be extremely careful with futures contracts because of the high level of borrowing typically involved. Borrowing large amounts, coupled with the extreme volatility of many commodity prices, makes futures trading particularly risky.
With inflation continuing to climb, the rally in commodities does not look likely to slow down any time soon. Stepping up for the ride, even at these elevated levels, is tempting.
But remember this: investing in commodities is always a high-risk, high-reward proposition, no matter when, what and how. Newer investors may prefer a low-stakes alternative, such as an app that lets you invest with only your ‘change’.
To minimize that risk, consider leaning the vast majority of your exposure to dividend-paying commodity producers and established commodity ETFs – and stay as far off the margin as humanly possible.