Should You Invest In Commodities?

Where do Commodities Fit in Your Portfolio?

Portfolio diversification comes in many forms — different asset classes, different industries, different investment strategies, and more. Adding a commodities allocation to a portfolio can provide an inflation hedge, offer long-term growth prospects, and reduce correlation to the public markets. Since commodities, stocks, and bonds have different underlying economic drivers, commodity prices may remain steady when stocks and bonds are more volatile.

For those reasons and more, commodities are a popular option among investors looking to add diversity to their portfolios without compromising on overall returns.

Commodities are the raw materials that go into products that people worldwide use every day. [1] This includes agricultural products like cotton, coffee, soybeans, and wheat; energy sources like crude oil and natural gas; precious metals like gold and silver bullion; and industrial metals like copper, zinc, and aluminum. Unlike stocks and bonds, commodity prices do not tend to rise and fall based on market sentiment but are instead tied to broader forces such as demand and supply, often resulting in more stable pricing over time.

Is that a good thing? It depends on your portfolio strategy and investment goals. But, for the most part, commodities investors enjoy a range of benefits by investing in this asset class, provided they also understand what makes commodities unique and deploy them strategically as part of their overall investment strategy.

Check out Commodities Explained to learn more.

The Case for Commodities Investing

That said, investing in commodities has unique pros and cons versus more common assets and products like equities, ETFs, and mutual funds. That’s because, unlike other investments, commodities call for different investment strategies, including mechanisms like commodity futures contracts and physical assets.

Some benefits of investing in commodities include:

• Inflation hedge: The diversification offered by adding commodities to your portfolio also safeguards it against inflation since the prices of commodities rise in response to high inflation. Read more about the inflation hedge properties of commodities in Notes on Inflation.

• Diversification: When viewed as an asset class, commodities diversify your portfolio because of a low correlation with stocks and bonds. You can trade in various commodities and leverage market supercycles to reap profits.

• Volatility Hedging: As physical goods, commodities can offer investors a measure of safety when conditions in the stock market get volatile. After all, the need for industrial metals, agricultural commodities, and other assets doesn’t go away just because the spot price swings. To illustrate this point, consider how wheat exports in Ukraine have continued despite broader geopolitical unrest.

There are good reasons that some of the best long-term investors in history have incorporated commodities into their trading strategies. Ray Dalio, for instance, made his name in the market with his All-Weather Investment Strategy, created in the early 1970s in response to the US dollar breaking from the gold standard. [2] It addressed a straightforward question: “what kind of investment portfolio would you hold that would perform well across all environments, be it a devaluation or something completely different?” The answer is a balanced strategy that weighs risk against more stable assets like commodities.

The Artemis Dragon Portfolio is another example of this thinking in action. “The solution to the successful 100-year portfolio is clear when you study financial history: balance assets that profit from secular growth (Serpent) with those that profit from secular decline (Hawk). When you combine the two, you achieve a steady portfolio, regardless of inflation or deflation”.

By blending commodities futures, swing trading, and other investment strategies, Artemis aims to protect its portfolio from price fluctuations and economic factors like political unrest, natural disasters, and even wars by keeping the portfolio consistent and balanced.

Considerations for Commodity Investing

But are commodities right for an individual investor’s portfolio? It depends on your experience level and understanding of this market segment. Although commodity investing offers upside potential, it has some drawbacks that you should consider when making investment decisions.

• Taxes: Unlike stocks, mutual funds, or exchange-traded funds, many commodity investments are treated differently for tax purposes. You may receive a K-1 at the end of the year to include your underlying commodity holdings on your taxes. The tax code requires you to declare your profits and losses and the value of your portfolio and apply for investments made in a partnership. For investors trading in different commodities, the K-1 schedule usually applies to citizens invested in limited partnerships and commodity fundETFs.

• Complexity: The investment strategies used by commodities traders include investment instruments like futures contracts and derivatives whose value depends on more factors than just commodity prices. Factors like roll yield, convenience yield, and interest rates may impact futures trading returns positively or negatively, especially over the short term. In addition, the underlying commodities are affected by market sentiment, which leads to price fluctuation of the derivative, making it hard to project returns. Investors can look at changes in oil prices and the corresponding move in Oil ETFs to see this relationship in practice.

• Liquidity: Commodities are illiquid investments and do not provide stable dividends. After all, if you buy a barrel of oil or a soybean harvest, you need to find a buyer before you can expect a return on that investment. In addition, larger supply and demand dynamics can impact commodity prices, affecting your commodity portfolio's value. New investors may want to seek investment advice from a financial advisor on alternative investments like commodity markets before making decisions.

• Variety: Commodity investors can choose from several options when considering adding commodity exposure to their portfolio. Commodity stocks are liquid and easy to convert to cash, while commodity ETFs allow direct access to the underlying commodity without single-company risk. On the flip side, owning physical commodities is less flexible, and you may not be able to convert them to cash quickly; however, physical ownership can eliminate financial intermediaries and provide direct access to commodity prices.

Should You Invest in Commodities?

There are pros and cons to commodities investing, just as in other asset classes. Yes, commodity exposure can help provide downside protection to your portfolio, particularly when the equity markets are experiencing excessive volatility. And, yes, the diversification that comes with a commodity investment strategy helps investors tap new sources of growth across their portfolios.

But commodities are not perfect. This asset class can experience long periods of low or negative returns known as commodity supercycles, and subtle forces in specific industries can impact the price of a commodity. At the same time, commodity prices are based on supply and demand. No matter how much investor interest a given commodity is experiencing, its price in the long term relies on industrial or manufacturing usage.

Are commodities right for your portfolio?

Here is how to ensure commodities are a good fit for your portfolio.

Define your goals and consider your risk tolerance

Consider how comfortable you are with drawdowns and price swings and your comfort with personal finance topics like portfolio management and taxes. Evaluate how a commodity investment may help you reach your investing goals.

What type of portfolio are you looking to build?

A broadly diversified portfolio that seeks to deliver steady growth is quite different from an aggressive all-stock momentum portfolio. Be intentional about the type of portfolio you seek to build and how commodities may fit into that objective.

What is your time horizon?  

Will you need the money in your portfolio this month, this year, or decades from now? Knowing how long you have for your investment strategy to play out is essential when considering less liquid investments like commodities. In addition, investors should consider their expectations for future returns and not simply look at the past performance of commodity indices.

Consider commodity strategies

Commodities can be effective for investors looking for an inflation hedge, portfolio diversification, or long-term growth. With that in mind, look at different commodity strategies to determine if there is one that matches your motivations and risk tolerance.

If you think commodities may be a good fit for your portfolio, check out Hedging Portfolio Risk by Investing in Commodities to learn more about investing in this asset class.

Investing in Commodities with Composer

Whatever role commodities may have in your portfolio, there is no substitute for research when considering a new asset class or investment strategy. Composer makes it easy to backtest returns to understand how commodities and related strategies have behaved historically to make informed determinations about future action. Use that data to analyze past cycles, evaluate pricing correlations, and determine the broader forces at work during earlier drawdowns.

It’s all about tapping the full array of available information when making portfolio decisions, including using Composer’s pre-made commodity trading strategies. Get started with Composer today.