Investors seeking the perfect stock market hedge just might find it by investing in commodities.
Commodities are the raw materials that are either consumed or used to build other products. From orange juice, to timber, oil and gas or gold, commodities take many forms.
The beauty of diversifying with commodities is that when one asset goes down, investors own others that will offset the loss and rise in price. The lower the correlation between assets, the greater the diversification benefit. Investing in less correlated assets keeps an investment portfolio from extreme volatility. For instance, it's much easier to digest a 10% loss than it is a 30% decline.
Another reason to consider investing in the commodity market is its low correlation with stock market returns.
"While many see commodity investing as intimidating and risky, investing in commodities is actually a great hedge when the stock market is falling. Historically, investments in crops, metals, energy, currencies and other tangibles are negatively correlated with both stocks and bonds – when the market goes down, the value of commodity investments go up," said Manav Garg, CEO and founder of Eka Software, a digital commodity management platform.
Another reason to invest in commodities is it offers the ability to shield against inflation. As prices rise, and goods become more expensive, commodity prices also increase. With commodities at the epicenter of the global supply chain, an investment in commodities can act as an effective inflation hedge, says Karen Harding, a chartered financial analyst and partner at NEPC in Portland, Oregon.
In sum, investing in commodities can offset the loss in purchasing power that arises from inflation and minimize investment volatility.
Here are answers to a few common questions about this type of investment:
- How to invest in commodities?
- What are the risks?
- Is investing in this type of asset right for you?
How to Invest in Commodities?
Investing in commodities isn't as simple as purchasing a barrel of oil or a bar of gold, storing it in your basement and redeeming it for a higher price in the future. A more practical way to invest in commodities is to buy the stocks and bonds of commodity producers.
BHP Group (ticker: BHP) operates in 25 countries and extracts various commodities from oil, gas, coal, and copper to iron ore – it's one example of a commodity stock that spans the globe. Another example: Barrick Gold Corp. (GOLD), a Toronto-headquartered metals miner with international interests and gold, copper and silver mining activities.
Another way to invest in commodities is through a commodity futures fund. The Bloomberg Commodity Index, known as the BCOM, tracks the futures market of various commodities, such as metals, agricultural products, energy and livestock. A futures commodity contract is an agreement to buy or sell a particular commodity at a predetermined price at a specified time in the future.
Mayra Rodriguez Valladares, managing principal at MRV Associates in New York and suggests investing in commodity-linked notes which are fixed income products that have returns tied to commodity baskets or indices. These fixed bond-like investments can be bought through an investment broker.
What Are the Risks of Investing in Commodities?
Commodities do have risks, distinct from the perils of investing in the stock and bond markets. Many variables impact commodities pricing.
"Commodity prices are among the most volatile of any market due to their sensitivity to country, economic, and operational risks such as strikes, unexpected harsh weather, terrorist attacks, and natural disasters," Valladares says.
While Martin Landry, senior portfolio manager at 1st Global in Dallas, says commodity futures are impacted by supply and demand for the commodity, along with storage, transportation and logistics of transporting the minerals, oil or other products.
Landry believes that the best time to own commodities is when inflation is high or when there is a scarcity of a commodity or excess demand. When those conditions aren't in play, returns may suffer.
Since many commodities are international in nature, investment returns are also impacted by changes in the exchange rates between foreign currencies and the U.S. dollar.
Commodities prices are extremely volatile. Within a short time, prices can peak and trough dramatically.
Should You Be Investing in Commodities?
This type of investing is risky with tremendous volatility. The lack of correlation between commodities and typical stock and bond investments can be helpful at certain times, while during other periods commodity returns can drag down an investor's total returns.
Commodities investing is cyclical and distinct commodities offer varying returns. Over the past 10 years, the S&P GSCI commodity index price peaked in 2011 near 5,700, bottomed in 2016 at 2,000 and is currently trading slightly above 2,600. While individual commodities follow their own ups and downs in price.
|Type of Commodity||Performance (2018)||Performance (2009)|
Data released by U.S. Global Investors shows the range of individual commodities returns. Notice that gold lost 1.58% last year and gained 24.36% in 2009. Natural gas lost value in both 2018 and 2009. These disparate returns are the norm among individual commodities.
Financial advisors' opinions on commodities investing vary. Viewing commodities as a whole misses the distinct variations in individual commodity performance. For instance, in 2017 aluminum returned 32.39% and lost 17.43% the following year. Gas gained 59.35% in 2016 and lost 20.7% in 2017 and 0.44% in 2018.
Many investment advisors recommend a small exposure to commodities to offset the volatility in stocks and bonds. A 5% interest in a diverse commodity fund is a reasonable allocation.
Picking specific commodity investments like betting on the direction of wheat or oil futures is quite speculative and best left to the professionals. Do-it-yourself investors are best served by investing in broad commodity funds unless they have specific knowledge about a particular commodity.