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What to Know About Investing In Commodities

Debbie Carlson

Investors seeking markets uncorrelated to the stock market may look to commodities.

Commodities are the raw materials that are either consumed or used to build other products. From orange juice to cotton, oil and gas to gold, commodities take many forms.

They are an alternative asset class to stocks and bonds. Commodities are generally uncorrelated to these traditional asset classes, but that's not always the case. In the current bear market environment, stocks are down because of a global recession. That's hit demand for many industrial commodities -- such as crude oil and copper -- pulling many commodities indexes lower.

However, other commodities are rising. Take gold, for example, which traditionally acts as a safe haven when traditional markets fall.

Roland Morris, portfolio manager and strategist with VanEck, says whether commodities rise when traditional assets fall depends on the reason why traditional assets are down.

"If it's like the 1970s, when there [was] inflation and strong nominal growth, then commodities are the only thing you want," he says.

But the current situation is deflationary because of the decline in economic activity, he says. However, Morris notes that investing during a bear market can position buyers for future gains when demand snaps back.

"Because of the demand shock, a lot of production is being shut down," Morris says. "Meat-processing plants have shut down production; farmers don't increase their herds, so it sets up a cycle where the whole sector is undersupplied at some point."

[Read: How to Use Gold as an Investment in a Bear Market.]

The same is true for copper, platinum and palladium mines, which are temporarily shuttered. Morris says when those underground mines reopen, production will likely be lower because the concept of safety will change. "You won't be able to have a lot of miners in tight spaces," he says.

The inflation hedge is another reason to invest in commodities. 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.

To summarize, investing in commodities can offset the loss in purchasing power that arises from inflation and minimize investment volatility.

If you're interested in investing in this space, here are a few common questions that will likely come up:

-- How to invest in commodities?

-- Why is it risky to invest in a commodity?

-- Is investing in this type of asset right for you?

-- How do you allocate commodities in a portfolio?

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 more than a dozen 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 ( GOLD), a Toronto-headquartered metals miner with international interests and gold and copper mining activities.

Another way to invest in commodities is through an exchange-traded fund that invests in commodity futures -- a futures contract is an agreement to buy or sell a particular commodity at a predetermined price at a specified time in the future.

Commodity exchange-traded funds will follow an index of several commodities or just one. The United States Oil Fund (USO) holds short-term Nymex West Texas Intermediate futures contracts, and it's one of the biggest commodity ETFs. The iShares S&P GSCI Commodity Indexed Trust ( GSG) tracks the S&P GSCI, formerly the Goldman Sachs Commodity Index, which is comprised of several commodity futures markets.

Mayra Rodriguez Valladares, managing principal at MRV Associates in New York, suggests investing in commodity-linked notes, which are fixed income products that have returns tied to commodity baskets or indexes. These fixed, bond-like investments can be bought through an investment broker.

Why Is It Risky to Invest In a Commodity?

Commodities have risks that are distinct from the perils of investing in the stock and bond markets, as many variables impact commodities pricing.

In this space, prices are extremely volatile. Within a short time, commodity prices can peak and trough dramatically.

"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.

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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.

Should You Be Investing In Commodities?

This type of investing is risky and comes with tremendous volatility. The lack of correlation between commodities and typical stock and bond investments can be helpful at certain times, though commodity returns can drag down an investor's total returns during other periods.

Commodities investing is cyclical and distinct, so commodities offer varying returns. Over the past 10 years, the S&P GSCI index price peaked in 2011 near 5,700 and bottomed in April at 1261 -- mostly dragged down by weak oil prices. It currently trades slightly above 1,500.

Individual commodities also follow their own ups and downs in price.

TYPE OF COMMODITY

PERFORMANCE (2019)

PERFORMANCE (2010)

Palladium

54.2%

96.6%

Crude Oil

34.5%

15.1%

Nickel

31.5%

33.9%

Platinum

21.5%

20.8%

Gold

18.3%

29.5%

Silver

15.2%

83.2%

Wheat

11%

46.7%

Corn

3.4%

51.7%

Copper

3.4%

31.4%

Aluminum

-4.4%

12%

Lead

-4.7%

6.7%

Zinc

-9.5%

-3.4%

Coal

-18%

31.4%

Natural Gas

-25.5%

-20.9%

Data released by U.S. Global Investors shows the range of individual commodities returns. Notice that coal lost 18% last year and gained 31.4% in 2010. Natural gas lost value in both 2019 and 2010. Corn was up 3.4% last year, but it gained 51.7% in 2010. These disparate returns are the norm among individual commodities.

Portfolio Allocation

Financial advisors' opinions on commodities investing also varies. Viewing commodities as a whole misses the distinct variations in individual commodity performance. For instance, in 2019 -- when the S&P 500 finished nearly 30% higher -- gold rose by 18%, platinum jumped 21.5% and oil leaped up 34.5%.

[See: 7 Commodity Stocks to Buy for Great Dividends]

Many 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.



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