Hedging Portfolio Risk: How to Invest in Commodities

When the markets get volatile, many investors turn to commodities. This is nothing new; it has been core to market behavior for decades. But, given today’s access to new commodity investment strategies and tools, adding commodity exposure to your portfolio is easier (and less expensive) than ever.

That matters as inflation soars, rising interest rates and fluctuations in oil prices impact the bond market, and risky assets start to look a little too risky.

It makes sense, then, that Refinitiv Lipper reported net inflows of $7.9 to commodity funds in February 2022, the best month for the asset class since August 2020. The reason? Inflation fears driving investors to the commodities market.

Commodity investing provides investors a wide range of opportunities when the equity forecast turns dark and stock and bond mutual funds appear less attractive. What makes commodity investing particularly attractive during uncertain times is that these assets are tied to industry-specific demand and supply conditions often insulated from broader economic forces. In short: investing in commodities can provide an effective hedge to portfolio risk compared to typical stocks, bonds, and other funds.

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What are Commodities?

Commodities as an asset class refer to raw materials and unprocessed goods such as oil, precious metals, natural resources, and agricultural products used to make other products. These goods are usually mined, grown, or processed to provide other goods and services. Commodities are a type of real asset, meaning they are physical assets with intrinsic value due to their properties and substance. The two primary types of commodities are:

• Hard commodities: These require extraction or mining, like industrial or precious metals such as lithium, silver, palladium, gold, aluminum, and copper, as well as energy goods like natural gas, crude oil, petrol, and coal

• Soft commodities: These require physical rearing or growing, such as agricultural products, soybeans, livestock, various types of meat, and other food products.

How to Invest in Commodities

Investors have various options for entering the commodities market, from investing in physical commodities directly or indirectly by buying shares in exchange-traded funds (ETFs) or commodity stocks. A significant investment decision is how investors gain access to commodities or an individual commodity. The allocation should be carefully considered against the current backdrop of high inflation and volatile oil prices. Commodity futures contracts allow investors to access pricing trends across commodities without owning anything outright.

1. Physical Commodities

Purchasing and holding a physical commodity is the most straightforward way to invest in commodities, although likely not the most convenient. The process involves finding a dealer to sell you a specific commodity — such as physical gold, bullion, or a bushel of corn — directly and then holding onto that product for some time before reselling it at a profit.

However, investors must also consider their investment goals and logistics for delivery and storage when it comes to physical commodities. Unlike trading commodity-backed assets on a commodity exchange, this mode of investing in commodities is less liquid and requires some extra steps for investors. It is, however, popular among those looking to invest in gold and certain base metals because these assets can be easy to locate online, don’t go bad over time, and buyers can safely store and sell them at their convenience.

Advantages of Physical Commodities

• Investors can invest in precious and industrial metals, as well as other commodities

• No need for a middleman

• Can be easier to find online

Disadvantages of Physical Commodities

• Not all commodities can be purchased physically

• High transaction and storage costs

• Potential safety issues associated with ownership of high-value commodities (no recourse available)

• Physical commodities can even go bad over time, with no recourse

• Finding a buyer and selling the physical commodity at the end of the trade can be tedious and time-consuming, and this can create high liquidity costs

2. Commodity Futures Contracts

A futures contract is an agreement to purchase an underlying commodity at a specific price in the future. The trade, then, is based on whether or not the price of that commodity goes up or down before the contract ends. Instead of physically owning and possessing a commodity, a futures contract allows investors to use commodity derivatives to participate in futures trading. 

For example, an investor could enter into a commodity futures contract where they must purchase a barrel of crude oil at $100. If by the time the contract expires, the market price for a barrel of crude oil is $115, the investor purchases their barrel at $100 and sells it at a profit; however, if the price falls to $90, the $100 purchase under the terms of the contract results in a loss.

Advantages of Commodity Futures Contracts

• Cost-efficient commodity investment method provided that the trade goes as per your expectations

• Potentially high-reward investment strategy

• No need to physically own or store the commodity

• Potential to bet on the future price trends of a commodity

Disadvantages of Commodity Futures Contracts

• Commodity trading through futures contracts can be risky for individual investors, particularly those who are not savvy about the underlying mechanics of the commodities market.

• Potential for loss if the price goes against the contract

• If the trade goes below the maintenance margin, it can be expensive to keep adding more capital to hold the contract open

3. Commodity Stocks

A wide variety of public companies are actively engaged in the commodities market, such as those that mine precious metals or trade agricultural products. By purchasing these equities, investors can profit when commodity prices rise, or corporate efficiencies boost overall profitability.

However, it is worth noting that stock prices are directly affected by the company's operation, in addition to the commodity market. Thus, it is vital to do due diligence before buying any commodity stocks to find companies with robust business models and produce consistent profits.

Advantages of Commodity Stocks

• No need to own the commodities physically

• Potential for high profitability

• High liquidity and easy to trade on the open market at any time

• Access to public information about company operations

Disadvantages of Commodity Stocks

• Investors must do their due diligence on company operations and commodity market dynamics

• You’re at the mercy of both the public markets as well as the commodities index when it comes to prices

• Not tied solely to commodity prices, which introduces higher potential volatility in an equity-heavy portfolio

4. Commodity ETFs

For investors looking for the benefits of commodity stocks without the potential complications of corporate performance, commodity exchange-traded funds (ETFs) provide direct exposure to specific commodities with the liquidity and convenience of typical equities.

For instance, you can now invest in ETFs that own physical gold, gold futures contracts, and other commodities. These funds provide an easy way to diversify an investment portfolio and enable investors to tap rising commodity prices on an as-needed basis while maintaining the ability to sell their holdings at any time. That is because, with a commodity ETF, you gain broad exposure to the specific commodity's market without being overexposed to any one company.

However, this type of diversification will not shield you from a decline in the commodity price, so it’s critical to consider portfolio-level diversification, too.

Advantages of Commodity ETFs

• Function like individual stocks on a stock market as they are traded on the same stock exchanges

• Provide broad exposure to a particular asset class 

• Allows investors to manage risk efficiently

• Easy to trade and low transaction costs

Disadvantages of Commodity ETFs

• The commodity itself does not produce cash flow other than the return on the commodity price

• The tax liability from K-1 ETFs often surprises new long-term commodity investors as they are required to pay tax on their gains regardless of whether they realized any gains or sold their ETF shares. Calculations of potential investment returns should consider tax implications too

The Easiest Ways to Invest in Commodities

Simply put, commodity ETFs are the easiest way for new and experienced investors to add commodity exposure to their portfolios.

They offer direct exposure to the underlying commodity compared to commodity stocks, they are easy to trade, and their transaction costs are relatively low. They represent a high liquidity approach to a low liquidity corner of the market. Plus, investors can create trend-following and momentum strategies using commodity ETFs, making them easy to incorporate into a range of trading strategies.

However, commodity prices are often volatile, and the wide variety of commodity options may be daunting at first. And that’s even before thinking about risk management. Therefore, research is critical in creating and executing on any commodity investing strategy, especially for beginners. Composer makes research and testing easier through our wide range of technical analysis and backtesting tools, including leading indicators for commodity investing. We have even created a few pre-made strategies that aim to make the transition to commodity investing smoother, including:

• Crude Reality Smarter Oil Playbook: Buying and holding an oil ETF can be less than ideal because oil ETFs typically invest in oil futures and can suffer from negative roll yields. To help, this symphony adds in smart timing. If oil has recently been doing well, it holds an oil futures ETF. If not, it takes it easy with low-risk assets like gold and short-term treasury bonds.

• Commodity Momentum Symphony: This strategy holds a particular commodity if it has positive momentum - as long as it’s doing better than medium-term treasury bonds.

• Real Asset Symphony: With a focus on real assets, this strategy invests in gold, real estate, TIPs, silver, diversified commodities, oil, and timber, all as hedges against inflation and market turmoil.