Classic Commodity ETF Investment Strategies

With commodity futures, natural resources, precious metals, physical assets, and more, the commodities market is a different ballgame for investors.

As opposed to stocks, which represent ownership in a company, commodities represent ownership of physical goods. These include physical commodities like oil, natural gas, precious metals, and agricultural products like soybean, livestock, and other raw materials. We covered the nuts and bolts of commodities in a previous post.

A key concept to remember when investing in commodities is that they’re interchangeable, meaning the same asset holds the same value. The gold I own is just as valuable as the gold you own, as opposed to equities, where companies in the same industry can have different valuations.

Commodities tend to come up in conversation whenever markets become volatile, and interest rates start rising. Over the years, they have proven to be an effective hedge against market volatility for retail investors and portfolio managers. With the right investment strategy, they can be an excellent way to introduce some diversification to your portfolio. Here are some strategies to consider if you’re interested in dipping your toes into commodity trading.

Benefits of Commodity Investing

Before we get our hands dirty, let’s discuss why someone would want to invest in commodities instead of stocks or bonds. Commodity trading offers some unique advantages compared to traditional investments.

Inflation Hedge: Recent market conditions have the US Treasury Secretary warning of a “dangerous and volatile environment”—primarily driven by high inflation. During periods of high inflation, stocks and bonds tend to stall or dip, while commodities tend to rise. Some commodities are over 40% above pre-pandemic levels, even after recent dips.

Holding commodities or commodity stocks can help your portfolio hedge against periods of high inflation and volatility, offsetting losses or lower-than-expected returns from stocks and bonds.

Learn more about hedging risk with commodities.

Portfolio Diversification: From hard commodities like metals, oil, and natural gas to soft commodities like crops and livestock, there are various options for investors. Allocating assets to commodities opens up several unique investment opportunities. And it’s not just the commodities that offer diversification, it’s how you choose to invest in them. Futures contracts, commodity stocks, and exchange-traded funds (ETFs) that track an underlying commodity are the most common choices, offering varying levels of liquidity.

Much in the same way commodities can hedge against inflation, commodity investments may offer meaningful returns during periods of high market volatility. When assets like stocks aren’t performing well, the commodities in your portfolio could bring balance and mitigate overall risk.

Growth Potential: Commodity prices can be volatile and prone to macroeconomic factors like geopolitical conflict and supply chains. But if a portfolio is built to weather that volatility, the potential returns can be compelling. In the shadow of the COVID-19 pandemic, commodity prices have fluctuated, but overall commodity prices are much higher now compared to pre-pandemic levels.

Disadvantages of Commodity Investing

Similar to any investment vehicle, while commodity investing offers a range of benefits, they also come with certain drawbacks that you should consider:

High Volatility: While commodity ETFs are a great way to hedge against inflation, they are also known for their extreme volatility due to the fluctuating prices of the underlying commodities. The underlying commodities are subject to many external factors such as changes in global supply and demand, natural disasters, and geopolitical events.

Future Investing: Many commodity ETF’s invest in futures contracts rather than holding the physical commodities. This runs the risk of a contango state where you would not earn any income as you would be buying high and selling low with every contract rollover. Commodity ETFs can also influence futures pricing due to the large number of future contracts being bought and sold, placing the ETFs at the mercy of traders.

Lack of Income Generation: Unlike other investment vehicles such as stocks or bonds, commodity ETFs do not typically generate any form of income through dividends or interest. The ETFs purely focus on tracking the movements of commodities and do not offer any regular payments making them undesirable for investors seeking a steady income.

Learn more about the value of adding commodities to your portfolio.

Four Types of Commodity Investment Strategies

Depending on your investment objectives, there are different investment vehicles to access the commodity market. Investors trade commodities through equities, ETFs, and even more exotic types of investments, such as derivatives. As you might expect, investing in commodities isn’t just a game of throwing spaghetti at the wall and seeing what sticks. There are some tried and true strategies that commodity traders follow.

Trend Following 

An old saying circulates in commodity trading circles: “The trend is your friend.” And it’s true.

Trend following is a reasonably straightforward approach to making investment decisions for active traders. When market prices are trending up, buy with the assumption they’ll continue to climb. When the trend line curves down, move to less risk-exposed investments until conditions improve. The core assumption in trend following is that as a trend emerges, it will continue for a significant period. When dealing with fluctuating assets, like crude oil prices, successful trend following can come down to timing instead of focusing on detailed fundamentals.

And how do traders know this strategy works? Turtles.

Or, more specifically, The Turtle Trader, the results of a bet between two prominent futures traders of the ‘80s where a group of novice traders saw enormous success using trend following.

Trend following is also present, and in some ways interchangeable, with the notion of commodity momentum. Trend following compares asset performance to some benchmark, while momentum strategies evaluate the relative performance of all the assets included in the universe.

Momentum Trading

Many classic trading strategies involve making long-term bets. But momentum trading rejects that idea, focusing on price fluctuations and past performance in the short term.

This is a similar strategy to trend following in that momentum traders closely watch for technical indicators that an asset price is trending upward. But, instead of watching for trend lines, momentum trading involves predicting when an asset has hit its peak. Once an asset has peaked according to the momentum trading algorithm, it is sold off. Instead of “buy low, sell high,” momentum trading follows the mantra of “buy high, sell higher.” 

Research has shown that a momentum strategy can outperform the market, but it’s not for every individual investor, considering the deep technical knowledge and timing it requires. Momentum trading requires a step-by-step approach and advanced planning to be successful.

While momentum trading has long been a staple of traditional equity trading, it works with commodity-linked assets too. The same basic principles that lead to success in traditional momentum trading can be applied to commodity markets. In fact, given the inherent volatility of commodities, momentum trading offers a way to make sense of the chaos—and benefit from it. 

Inverse Volatility 

Inverse volatility involves weighting assets based on the volatility or riskiness of their returns. Risk-based weighting is essentially a bet that increasing volatility foreshadows drawdowns and poor performance. Reducing a portfolio’s allocation to more volatile assets may not be a recipe for eye-popping returns, but it is a safe bet for managing portfolio fluctuations.

Inverse volatility can help reduce the overall variability of your portfolio and improve performance by reducing exposure to assets as they get more volatile (a potential sign of upcoming drawdowns). You can take advantage of inverse volatility by manually calculating standard deviations with python or excel or by using an automated trading service like Composer. 

Investors can reduce their risk to commodities as they become more volatile using an inverse volatility strategy. Some commodities like gold, silver, and real estate are also called real assets and are perfect candidates for inverse volatility weighting. That is why they make up Composer’s real assets strategy: Get Real: The Real Asset Portfolio.

Buy-and-Hold

The antithesis to trend- and momentum-based trading, buy-and-hold is the ultimate long-term strategy. Simply put, buy an asset and hold onto it. In the stock market, the titan of the investing world, Warren Buffett, might be the biggest proponent of this strategy.

Buy-and-hold can also work for commodity investing, but investors need to understand the risks and tradeoffs of commodity investments. Commodity ETFs and mutual funds are best suited for buy-and-hold investors since they outsource the day-to-day management of the strategy to an investment manager.  

Index funds like the Invesco DB Commodity Index Tracking Fund, or DBC, are good entry points for buy-and-hold traders breaking into commodities. Invesco’s DBC tracks a benchmark made up of 14 of the most-traded commodities globally.

Index plus or roll-managed ETFs, similar to the Invesco Optimum Yield Diversified Commodity Strategy No K-1 ETF (PDBC), may also be a good choice for long-term commodity investments.

Actively managed ETFs like the Harbor All-Weather Inflation Focus ETF (HGER) offer exposure to inflation-sensitive commodities that are carefully weighted to boost long-term potential. 

Prior to investing in a mutual fund or ETF, investors should review the prospectus and complete due diligence on the issuing asset manager.

As commodity markets continue to evolve, having a handle on the most popular and the most successful commodity investment strategies will give investors a leg up as they explore the potential of this asset class. And, as inflation confounds investors and economists, you can expect commodities to continue to receive attention.