Are Commodities High Risk?

Investors gasped when they saw the Consumer Price Index, a key inflation measure, come in at 8.5% for July 2022. This year-over-year increase in consumer prices was the highest CPI growth number that the United States has experienced in the past four decades. Inflation has eased slightly in the latest print, but only just so, and interest rates remain elevated. Inflation uncertainty and concerns about economic growth have sent stocks whipsawing back and forth.

During times of market volatility like these, many individual investors will seek some level of protection through portfolio diversification, allocating capital to bonds and commodities to complement riskier assets like stocks. Since the commodity asset class includes a wide variety of physical goods such as oil & gas, agricultural products, and precious metals, commodity prices tend to rise and fall based on different factors than stocks or bonds, helping to reduce overall portfolio volatility.

But that doesn’t mean that commodity trading is without risk. Trading in commodity markets calls for a different investing mindset, particularly around liquidity and risk management, in order to be successful.

If you're looking to create a ChatGPT AI trading bot with commodities, click here.

What are Commodity Investments?

Investors trade in various types of commodities such as crude oil, natural gas, industrial metals, soybeans, coffee, sugar, pork bellies, agricultural inputs, and other raw materials. However, they don't simply trade dollars for the physical commodity. Instead, commodity investors will often trade securitized versions of these assets that represent a claim on the physical commodity. This makes it easier to trade commodities and gain commodity exposure like one would on the stock market, without the hassle of storing or transporting actual goods.

Thus, there are a variety of trading strategies that an investor may pursue to invest in commodities today. And the risk associated with commodities as an asset class depends on your investment strategy. Common ways to invest in commodities include:

• Commodity stocks

• ETFs and mutual funds

• Commodity futures

Find out more about what a commodity is here.

Commodity Stocks

Certain public companies, such as oil and gas producers or gold miners, trade as stand-ins for the commodities they are focused on. These stocks often move up or down with the prices of their underlying commodity, for example, oil prices. While there are other factors that play into how commodity stocks trade, such as debt levels and how well-run the company is, many investors use them as vehicles for gaining economic exposure to a particular commodity. The key risks for commodity stocks are general market risk (e.g., stocks fall out of favor), company-specific risk (e.g., refinery accident), and commodity risk (e.g., commodity prices fall)

ETFs and Mutual Funds

Exchange-traded funds (ETFs) and mutual funds are easy ways to invest in commodities. ETFs are increasingly popular as they represent a way to make a diversified investment into a particular commodity. In addition, ETFs trade throughout the day just like equities, so traders can exit positions at will. Given their liquidity, ETFs are popular with hedge funds and algorithmic investors.

Mutual funds offer similar access to a basket of commodities, but since they only price once per day and can come with added fees, they tend to attract less active commodity investors who are looking to buy and hold their investments over long periods of time.

The important risks for ETFs and mutual funds are detailed in their prospectus, and it’s good practice to review these before investing. The funds will be sensitive to changes in commodity prices and could drop in value if the price of underlying commodities drops. For the investor, the holdings in the fund are largely out of their control, so it’s important to understand how the manager invests and how much value the fund could lose during your holding period. Lastly, investors need to consider management or issuer risk. Is the management reputable, and will the fund be around for the foreseeable future?

Commodity Futures and Derivatives 

Commodity futures trading is by far the riskiest way to invest in commodities. When an investor buys or sells commodity futures contracts and derivatives, they are essentially betting on the rise or decline of the price of that commodity in a set period of time.

For example, let’s say that an investor notices that the current price of sugar is 17.8 cents per pound. If they believe that the price will increase, they might purchase futures contracts that require the purchase of sugar at 17.8 cents per pound price at a set time in the future. The bet is that, if the future price increases (say, to 20 cents per pound), then the investors can buy sugar at 17.8 cents per pound and immediately sell it for the current market price of 20 cents. In practice, investors generally close their positions before expiration to avoid physically buying and selling the underlying commodity. However, if the price of sugar falls, the investor is obligated to purchase the agreed-upon amount at 17.8 cents per pound (or close their contracts at a loss) That’s the risk of trading the futures market.

These types of derivative trades carry more risk because small price changes in commodities can be amplified by the number of contracts that an investor purchases. ETFs and mutual funds often use futures contracts responsibly and have long track records of performance that investors can evaluate. When considering investing in derivative contracts for commodities, make sure you do your homework and understand the risks involved in each trade. The potential high returns may be enticing, but futures trading comes with high risks.

Understanding Portfolio Risk

Naturally, all investments carry some level of risk, and commodities are no exception. But there are some that are far higher on the risk scale than others. Depending on the type of investor you are, your risk tolerance, and the goals of your investment portfolio, more or less risk may be advisable. These are critical investment decisions that should be well thought through as part of a sound investment strategy for long-term wealth management.

To define risk in an investment, consider using standard deviation, like what we calculate at Composer. When investment returns on a particular investment vary wildly from year to year, the standard deviation on that asset will be higher. This should be viewed as a flashing red warning sign that a particular investment is volatile and risky. Conversely, a low standard deviation number means that the returns for a given investment have generally been stable and less prone to fluctuations. 

Bare in mind that stable returns do NOT necessarily mean large returns. Instead, it simply means that an investor may expect a less bumpy ride from low standard deviation investments. Backtesting commodity ETFs can give you a sense of commodities risk profile. Here we show a ten-year backtest for a handful of commodity ETFs:

• Gold (GLD)

• Agriculture (DBA)

• Base Metals (DBB)

• Oil (DBO)

• Uranium (URA)

• Timber (WOOD)

And here are the annualized standard deviations for that period.

What are Drawdowns? 

An important risk for commodity investors to consider is drawdown risk. If you have ever been on a rollercoaster, you know the pit in your stomach feeling that you get as the ride begins a rapid drop. This is part of the entertainment and enjoyment of a rollercoaster, but it is not nearly as fun to experience that feeling when reviewing your portfolio.

A portfolio with a declining value is experiencing a drawdown. This is defined as a peak-to-trough decline during a specific period of time, usually a percentage drop from the asset’s highs to its lows over either the short-term or long-term.

Drawdown figures can be useful risk indicators in two ways. They are an effective tool for measuring the potential future risk of a particular investment, based on past performance. In addition, they are an effective way to measure one's personal portfolio performance against a commodities index. Avoiding large drawdowns is critical to successful long-term commodity investing. 

An investment that has historically had large drawdowns may introduce additional risk to your portfolio. At the same time, an asset with a history of dramatic highs and lows can introduce opportunities to buy low and sell high. Volatility can be your friend or foe. It all depends on your risk tolerance and investing style.

How Composer Addresses Commodity Risk

It is fair to say that while there is some risk in commodity trading, there are ways to incorporate this asset class into a wide variety of investment strategies. Composer offers a number of different ways to invest in commodities without taking on undue risks.

• Backtest Commodity ETFs and Stocks: Review the historical data about any commodity ETF or stock that you are considering so you know how it has performed in the past, particularly in terms of past drawdowns and overall volatility. Although past performance is not a guarantee of future results, it may still be highly useful as far as getting a basic idea of what stock or ETF returns may do going forward.

• Visualize The Risk/Reward Ratio Before Trading: Never jump into any investment until you have visualized the full extent of the risk and reward that are possible. If the risk makes you too nervous to make the investment, then back off of it and look for other opportunities.

• Incorporate Investment Strategies Like Trend-Following to Reduce Drawdowns: In commodity investing, following the crowd can pay benefits in terms of long-term stability and risk management. By reviewing the overall market trends, Composer makes it easy for investors to analyze and execute trend-following strategies.