The terms commodities, futures, contracts, trades, and derivatives might sound complicated and may often be associated with big business and large Wall Street traders. But it is possible for Accredited Investors to access the world of commodities investing.
What are the 3 types of commodities?
So, what is a commodity? The simple answer is an agricultural product or natural resource that can be traded. It’s a long list, so to make these investments easier to understand and manage, commodities are generally grouped into the following three categories:
- Agricultural products such as wheat, cattle, orange juice, and cotton.
- Energy such as renewables, crude oil, natural gas, and gasoline.
- Metals such as gold, silver, and platinum.
What is a Futures Contract?
One method of commodity investing is when a buyer and a seller agree on a “contract for future delivery”, which is a legally binding contract to buy or sell a specified quantity of product at an agreed price at a nominated time in the future. Such an agreement is also known as a “futures contract”. Futures contracts are traded on a futures exchange, which is a marketplace that facilitates the buying and selling of commodities in a regulated environment.
A futures contract is a type of derivative product because it is valued on the basis of the price of an underlying asset.
Investing in commodities can be a hedge against inflation
Historical trends indicate that commodity prices tend to rise and fall along with inflation, which means that investing in commodities can potentially provide a hedge against inflation. As an example of a historical trend, the following chart shows the value of the Dow Jones Commodity Index vs. the US Inflation Rate (the Dow Jones Commodity Index is a broad indicator of the commodities market, being a weighted index that tracks 28 commodity futures contracts).
It can be seen from the chart below that across more than 11 years of data, the Commodities Index has shown a similar trend to the rise and fall of inflation.
Regarding the above, it is important to note that past performance is no guarantee of future performance.
How to invest in commodities
Portfolio diversification is an important concept for investors to manage risk and optimize returns. Investing in a balanced range of asset classes with varying degrees of risk, potential growth, and market sector exposure helps to diversify an investment portfolio.
Options for investing in commodities include:
- Direct investment in the commodity by physically purchasing the product, for example buying gold bullion and storing it somewhere safe such as a bank vault (preferably not under your bed!).
- Investing in a hedge fund that trades in commodities.
- Purchasing shares in commodity companies.
- Purchasing shares of a Commodity ETF (Exchange Traded Fund), which tracks the performance of a specific commodity (such as oil, for example) or a range of commodities.
Risks of commodity investing
Commodity investing is a high-risk undertaking. External factors such as weather effects, crop yields, geopolitical influences, economic conditions, conflicts (such as the Russia / Ukraine war), and more can cause sharp changes in the price of the underlying commodity. The use of futures contracts with legal requirements for fulfillment at agreed prices can create the potential for significant losses if the price moves in the wrong direction for the investor.
Another prominent risk of commodity investing is the use of leverage, which is when traders utilize borrowed funds to finance their deals. If the price moves against the holder of the futures contract, their exposure may be increased due to leveraged positions, with the potential for margin calls that may magnify losses.
Risk is present on both the supply and demand sides of commodity investing, both of which can influence the price. For example, a bumper crop of wheat could increase supply, which may drive down prices. Or demand for meat products might fall due to concerns around price, the environment, or diet trends, which could drive prices down.
In general, commodities have higher volatility than other assets such as stocks or bonds, so volatility risk in commodities is an important consideration.
Pros and cons of commodity investing
The pros of commodity investing can include:
- Potential to provide a hedge against inflation.
- Portfolio diversification.
- Potential to act as a hedge against currency devaluation.
- Opportunity for investment returns under favorable market conditions.
The cons of commodity investing can include:
- High volatility.
- The use of leverage can magnify losses.
- Speculative trading activity can influence the market independently of the value of the underlying asset.
Commodity hedge funds
Accredited Investors may choose to invest in a commodity hedge fund to gain exposure to commodities. Commodity funds may adopt one or more of the following strategies:
- Buy and hold the commodity asset itself.
- Trade in futures contracts, without owning the commodity asset itself.
- Invest in companies that own or produce commodities.
There are many commodity hedge funds in the marketplace from companies such as BlackRock, Elliott Management, and Svelland Capital. Depending on the fund manager’s stated objectives and investment approach, the fund may have a particular focus on a specific commodity or sector. For example, Svelland Capital is focused on the global energy transition from fossil fuels to zero carbon that is occurring in response to climate change.
Commodity investing provides an opportunity for investors to diversify their investment holdings, gain exposure to potential market gains, and possibly provide a hedge against inflation. Accredited investors can gain exposure to this sector by investing in commodity hedge funds.
This article is for informational purposes only. We do not provide legal, financial, or tax advice and investors should consult their advisors prior to making any investment. As with any investment, past performance is no guarantee of future performance, and any investment decision must balance the risk against the potential return. Private investments are highly illiquid and risky and are not suitable for all investors. There is no guarantee that a liquidity event will ever take place.
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