Commodities are the driving force behind the global economy, presenting unique opportunities for professional investors to capitalise on their dynamic price changes. However, engaging in commodities investing requires knowledge and may entail higher risk compared to traditional asset classes such as stocks and bonds.

These raw materials are the bedrock of the global economy, exerting significant influence across many industries. The combination of price volatility, high market liquidity, and the potential for portfolio diversification, makes commodity trading particularly attractive to traders.

What Are Commodities?

Commodities are raw materials integral to the production of finished goods, such as agricultural products, mineral ores, and fossil fuels. Within the context of financial markets, commodities are physical goods that are bought, sold, and traded in markets, unlike stocks and bonds that exist solely as financial contracts.

Main types of commodities:

• Energy: The energy sector includes vital resources like oil, natural gas, coal, ethanol, and uranium. Energy also extends to renewable energy sources such as wind power and solar power.
• Metals: Commodity metals fall into two main categories: precious metals and industrial metals. Precious metals include gold, silver, palladium, and platinum, while industrial metals are any type of base metals used for industrial purposes and consist of iron ore, tin, copper, aluminium, and zinc.
• Agricultural commodities: Agricultural products include both consumable and non-consumable goods. Edible products include commodities like cocoa, grain, sugar, and wheat. Non-edible items include cotton, palm oil and rubber.
• Livestock. Livestock covers all live animals, such as cattle and hogs.

Investors participating in the commodity market strategically aim to take advantage from supply and demand trends or mitigate risk by diversifying their portfolios by including different asset classes.

Advantages of investing in commodities

In the last decade, investors have been increasingly exploring new investment markets. Currently, commodities stand out as one of the most popular asset classes, offering unique advantages, notably a negative correlation with the stock market.

• Portfolio diversification:Commodities exhibit low or negative correlation with traditional asset classes like stocks and bonds. This unique characteristic makes them an effective tool for portfolio diversification, offering a hedge against market volatility. The inclusion of commodities in a portfolio contributes to risk reduction and enhances overall diversification.

• Hedge against inflation: Commodities can serve as a robust hedge during periods of high inflation. Historically commodities have often performed well during inflationary periods, even when shares and bonds have experienced declines. As demand for goods and services rises, leading increased prices, the value of commodities used in production tends to follow suit.
• High leverage: Commodity Exchange Traded Products (ETPs) based on futures contracts provide investors with the opportunity for high leverage. Investors can control a large position by committing only a fraction of the contract value. Consequently, even a small price movement in commodities can result in amplified gains or losses, offering the potential for enhanced returns.

Commodities market investors strategically leverage these unique advantages to optimise their portfolios, manage risk, and capitalise on the ever-changing commodities prices.

How to Trade Commodities

Trading commodities presents a challenge due to the impracticality and costliness of direct investments in physical assets. Consequently, only a small number of investors choose to engage with commodities in their tangible form. Instead, the majority opt for exposure through financial instruments such as futures contracts, Exchange Traded Funds (ETFs), or Exchange Traded Commodities (ETCs). Neither of these types of instruments provides perfect price tracking of the day-to-day spot price movements of the underlying commodities; however, each can offer some exposure.

• Futures contracts: Investors can gain exposure to commodities through futures contracts. These contracts not only reflect current price movements but also encapsulate market expectations for future commodity prices. A futures contract is a commitment to buy or sell an asset at a predetermined price on a specified future date. As the contract approaches expiration, the fund may roll over the futures position to avoid physical delivery of the commodity.
• Exchange-Traded Funds (ETFs) and Exchange-Traded Commodities (ETCs): These investment vehicles offer an accessible avenue for investors to participate in the commodities market. ETFs and ETCs are structured to track single commodity prices or baskets of commodities, allowing investors to trade these instruments on exchanges like stocks.
• Rollover and expiry: In the case of futures contracts, the impending expiry date requires a strategic approach. To prevent actual delivery of the commodity, funds engaging in futures contracts typically employ rollover strategies. This involves transitioning from one futures contract to another, thereby extending exposure without the need for physical delivery.

Commodities ETCs and their role in a portfolio

Historically characterized by lower long-term returns and heightened volatility, commodities require a cautious approach to portfolio allocation. A prudent guideline suggests a modest, low double-digit percentage allocation from the overall portfolio to commodities.

Commodities are a distinct asset class and exhibit a historical tendency to behave differently from stocks and bonds. Their performance is less dependent on business prospects or interest rates and more influenced by factors such as supply and demand, weather patterns, and decisions by entities like OPEC+.

The performance of commodities, in contrast to traditional assets, tends to be marked by higher volatility and underperformance over longer periods. However, commodities demonstrate strong trending over shorter periods, presenting tactical trading opportunities for astute investors.

A prevalent motive for investing in commodities is their historical alignment with rising inflation. In periods of either rising or persisting inflation, a commodities allocation can prove beneficial. Additionally, commodities can serve as a form of insurance against geopolitical risks, such as wars or conflicts, impacting prices of essential commodities like grains and energy.

Given the unique characteristics of commodities, investors are urged to carefully assess their objectives and risk tolerance before incorporating them into their portfolios. While commodities offer potential benefits, including diversification and inflation protection, their distinct performance drivers require a thoughtful approach to allocation.

Conclusion

Investors can gain exposure to commodities by investing in futures contracts, ETFs or ETCs which directly track a specific commodity. These are highly volatile and complex investments that are generally recommended for sophisticated investors only.

Commodity ETCs provide investors with easy and inexpensive access to various commodity markets, helping them diversify portfolios and offer a hedge against inflation, and geo- political risks.

Individual commodity prices can fluctuate due to factors such as supply and demand, exchange rates, inflation, and the overall health of the economy, and display strong short term trends.