What Are Commodities?

What are commodities, and do they belong in your portfolio?

Commodities hold an interesting position in the investing markets. Instead of buying a stake in a company, buying a commodity often means purchasing a securitized version of a raw material that is valuable to someone else. You’re betting on the increase or decrease in that commodity’s value while you own it. Precious metals, crude oil, natural gas, live cattle, and soybeans are commodities. They are typically viewed as a hedge against inflation.

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The key here to defining a commodity is interchangeability. All things being equal, the crude oil you own is just as valuable as the oil I own. In other words, while the value of crude oil in the world might increase or decrease over time due to natural disasters, fluctuations in demand, or other types of volatility, all crude oil is worth roughly the same amount at any given moment.

Another way to think about it is in terms of fungibility. Most, but not all, commodities are fungible, meaning that they can be traded and split without issue. You can sell another investor any amount of gold, silver, or crude oil you want. Commodities as an asset class can be broken down into smaller and smaller amounts.

You may be confused about how commodities can be fungible but also include assets such as livestock. Not all livestock are commodities; some are graded and authenticated as higher than commodity value. [1] Non-fungible things can be made fungible by a lack of assessment and intent to break them down into parts before selling them. In the case of commodity cattle, this often means that they’ll be turned into food of varying but average value before they are sold.

Futures Contracts vs. Physical Ownership of Commodities

Futures contracts are often used by companies and investors trying to lock in prices for commodities in the future. For example, producers of commodities like crude oil need to know that they can sell their product above a break-even price. Users of commodities need to know that they can acquire essential materials for a standard price. Both parties enter the futures market to ensure that they can buy and sell hard and soft commodities in question when they need them.

The total sum of money and the commodity in question are not exchanged upon signing the commodity futures contract. Instead, it’s simply a guarantee of the future exchange of physical commodities. These contracts can be bought and sold without ever taking physical delivery of commodities, allowing investors to access the benefits of ownership without the hassle of storing and maintaining the commodities. Commodity futures sales are regulated by the Securities and Exchange Commission and the Commodity Futures Trading Commission.

Investing in Commodities

Commodities are everywhere, and we use them or their derivatives every day. Energy commodities like fossil fuels produce a large proportion of the electricity we use in our homes. We eat the products of agricultural commodities, and natural resources are used to build the world around us. But how can investors access this asset class for returns and diversification?

As discussed above, there are many different commodities, and each can deliver a unique return stream for investors’ portfolios. For example, oil prices may behave differently than prices for agricultural products following a significant macroeconomic development.

The difference between commodities and stocks is simple: stocks are a way of buying a piece of a company and gaining control/ownership of it, and commodities are interchangeable physical assets. Stocks are traded on the stock market, while commodities and futures are traded on exchanges like the Chicago Mercantile Exchange (CME). Commodity Exchange-Traded Funds (ETFs) represent a hybrid option for investors where the ETF is traded like equities, but the underlying holdings are physical commodities or futures contracts.

Related: Hedging Portfolio Risk: How to Invest in Commodities >

The Role Commodities Play in a Portfolio

Commodities are often separated and protected from dips in stock and bond returns. The price movements of equities, bonds, and other classic investment classes seem to affect commodities less because they have different economic drivers.

This means investing a relatively small capital allocation into commodities can be a great way to stabilize your portfolio. One ETF, the Invesco DB Commodity Index Tracking Fund, has a low correlation with the S&P500 and aggregate bond market over the last three years, making it a great way to diversify your portfolio.

However, it’s important to remember that individual commodities are imperfectly correlated too. In other words, you may not get the same gains on the commodities market if you select a single commodity. Most experts will recommend that you diversify with a collection of commodities.

Considerations for Commodity Investing

However, just because they play a role in investment portfolios similar to other assets doesn’t mean that commodity investing is exactly like investing in stocks or bonds.

Tax reporting and K-1

Instead of reporting your taxes through a 1099, commodity ETFs must be reported through Schedule K-1s. The critical thing to remember here is that the taxation of gains realized through commodity trading is treated differently than equityETFs or mutual funds. This doesn’t mean that it’s not worth it; in fact, fluctuations in commodity prices can make trading well worth your while. However, most individual investors will want to closely read the prospectus of any commodity ETF and engage the services of a qualified tax professional if they have questions.

Futures contracts and negative roll yield

Futures contracts and other commodity trading is not always profitable. If the commodity in question is in a state of contango, meaning that the price of the commodity is rising faster than expected, investors may end up losing money on the contracts if they don’t quickly sell their contracts and move to a better position. This unfortunate result is known as negative roll yield.

Long periods of low or negative returns

Some commodities may have extremely long periods with little-to-no rise in price. However, this doesn’t mean that commodity trading is useless or unprofitable. These low return periods may frustrate buy-and-hold investors and test traders' skills. It’s important to remember why you chose to invest in commodities in the first place and stick to your strategic plan.

Commodity trend investing can be a viable strategy over the long term. Using financial instruments, like ETFs, and technical analysis, we can attempt to predict future prices for many commodities. Of course, this type of strategy works best over the long term by making good use of trends.

Related: Classic Commodity Investment Strategies >

Are Crypto Assets Commodities?

Virtual currencies, such as Bitcoin, have been declared commodities by the Commodity Exchange Act (CEA). In the same way, that money or gold is a commodity and can increase and decrease in value, crypto is a commodity. Crypto is, by definition, fungible and able to be broken down infinitely into smaller parts.

How to Invest in Commodities

Some of the most popular avenues for investing in commodities are mutual funds, ETFs, and futures contracts. Putting money into a fund that will buy a diverse grouping of commodities can help increase the stability of commodities while also raising the return rate.

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