Commodities: The Portfolio Hedge

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Commodities: The Portfolio Hedge

Most people see a futures market trading floor as a scene of complete pandemonium, complete with intense screaming bouts, frenetic hand signals, and high-strung traders jockeying to have their orders executed, which is not far from the reality. These marketplaces bring buyers and sellers together to exchange a diverse range of goods. Today’s commodities include agricultural items, metals, and petroleum, as well as financial instruments, foreign currencies, and stock indexes traded on commodity exchanges.

Products that provide a form of haven—a buffer against inflation—are at the heart of this alleged disease. Commodity prices often increase when inflation accelerates, providing insulation from the consequences of inflation. Rising inflation, especially unanticipated inflation, benefits few investments, but commodities typically do. The price of products and services grows as demand for them rises, as do the prices of the commodities required to generate those goods and services. Futures markets are therefore employed as continuous auction markets and clearinghouses for the most recent supply and demand information.

Key Takeaways

  • Commodities are manufactured or extracted things, often natural resources or agricultural commodities, that are frequently employed as inputs into other operations.
  • Many experts advocate allocating a portion of your portfolio to commodities as a diversifier asset class.
  • Furthermore, certain commodities, such as precious metals and energy items, tend to be ideal inflation hedges.

What Are Commodities?

Commodities are commodities that have similar quality and usefulness regardless of where they come from. When most people purchase an ear of corn or a bag of wheat flour at the store, they don’t think about where they were produced or processed. Commodity items are interchangeable, and under that broad definition, a wide range of things for which consumers don’t care about the brand might possibly qualify as commodities. Investors often have a more narrow perspective, referring to a restricted set of essential items that are in high demand across the world. Many commodities on which investors place their bets are raw ingredients for manufactured final items.

Commodities are classified into two types by investors: hard and soft. Metals such as gold, copper, and aluminum, as well as energy goods such as crude oil, natural gas, and unleaded gasoline, need mining or drilling. Soft commodities are agricultural products such as maize, wheat, soybeans, and livestock.

Benchmarks for Broad Commodity Investing

Benchmarking your portfolio performance is essential since it helps you to assess your risk tolerance and return expectations. More crucially, benchmarking allows you to compare your portfolio’s performance to that of the rest of the market.

The S&P GSCI Total Return Index is a wide commodity index and a useful benchmark for commodities. It owns all commodity futures contracts, including oil, wheat, maize, aluminum, live cattle, and gold. The S&P GSCI is a production-weighted index based on the importance of each commodity in the global economy, or commodities produced in bigger numbers, to provide a better indication of their market worth, comparable to market-cap-weighted stocks indexes. When compared to comparable indexes, the index is seen to be more reflective of the commodities market.

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Why Commodities Add Value

Commodities have a weak to negative connection with conventional asset classes such as equities and bonds. A correlation coefficient is a value between -1 and 1 that indicates how closely two variables are connected linearly. The correlation coefficient will be one if there is a perfect linear connection. A positive correlation indicates that when one variable has a high (low) value, the other does as well. If the two variables have a complete negative connection, the correlation coefficient will be -1. A negative correlation indicates that when one variable is low (high), the other is high (low). A correlation value of 0 indicates that the variables have no linear connection.

Typically, US equities, whether in the form of stocks or mutual funds, are closely tied to one another and have a positive correlation. Commodities, on the other hand, are a gamble on unanticipated inflation, and their connection to other asset classes is minimal to negative.

Commodities may and have provided exceptional returns, but they remain one of the most volatile asset types. They are more volatile (or risky) than most other stock investments. However, by include commodities in a portfolio of less volatile assets, the total portfolio risk is reduced owing to the negative correlation.

The S&P GSCI’s yearly performance has been negative in seven of the ten years from 2011 to 2020. As a result, some investors have questioned the utility of commodities in their portfolios and if commodity prices would continue to fall in the future.

How Volatile Are Different Commodities

Commodity prices are primarily affected by supply and demand dynamics. When a crop has a large harvest, its price normally falls, but drought circumstances might cause prices to climb due to worries that future supplies would be fewer than predicted. Similarly, when the weather is cold, demand for natural gas for heating causes prices to climb, whilst a mild spell during the winter months might cause prices to fall.

Volatility in commodities is greater than in stocks, bonds, and other forms of investments because supply and demand characteristics fluctuate often. Some commodities are more stable than others, such as gold, which is also used as a reserve asset by central banks to mitigate volatility. However, even gold may become volatile at times, and other commodities can fluctuate between stable and turbulent circumstances based on market dynamics.

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The History of Commodity Trading

For millennia, people have exchanged numerous commodities. The first official commodity exchanges were in Amsterdam in the 16th century and Osaka, Japan, in the 17th century. Commodity futures trading began at the Chicago Board of Trade, the forerunner to what became known as the New York Mercantile Exchange, only in the mid-nineteenth century.

Many early commodity trading marketplaces were the consequence of producers banding together to pursue a shared goal. Producers might assure orderly marketplaces and prevent fierce rivalry by pooling resources. Many commodity trading venues initially concentrated on specific items, but over time, these markets consolidated to become broader-based commodities trading exchanges with a diverse range of goods in the same location.

How to Invest inCommodities

There are four ways to invest in commodities:

  1. Investing in the commodity directly.
  2. Investing in commodities futures contracts.
  3. Investing in commodities-focused exchange-traded funds (ETFs).
  4. Purchasing equity in commodity-producing enterprises.

Direct Investment

Investing directly in a commodity necessitates its acquisition and storage. Finding a customer and managing delivery logistics are all part of selling a commodity. This may be possible with metal goods, bars, or coins, but bushels of maize or barrels of crude oil are more difficult.

Futures

Commodity futures contracts provide direct exposure to price movements in commodities. Commodity exposure is also provided by several ETFs. If you want to invest in the stock market, you may buy shares in firms that manufacture a certain commodity.

Commodity futures contracts obligate the investor to purchase or sell a certain quantity of a particular commodity at a specified price at a specified period in the future. To trade futures, investors must have a brokerage account or work with a stockbroker that specializes in futures trading.

When commodity prices rise, the value of a buyer’s contract rises while the seller loses money. When the price of a commodity falls, the seller of the futures contract benefits at the cost of the buyer.

Futures contracts are intended for significant corporations in the commodities market. One gold contract may necessitate the purchase of 100 troy ounces of gold, which could amount to a $150,000 investment, which is more risk than the ordinary investor wants in their portfolio.

ETFs

Individual investors often choose commodity-related ETFs. Some commodity ETFs purchase actual commodities and then sell shares to investors that reflect a certain quantity of the commodity.

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Futures contracts are used by several commodities ETFs. Futures pricing, on the other hand, take into account a commodity’s storage expenses. As a result, even if the market price of the commodity improves, a commodity that is expensive to store may not show benefits.

Commodities-Related Stocks

Shares in commodity producers may also be purchased by investors. Companies that extract crude oil and natural gas, for example, or cultivate crops and sell them to food manufacturers. Product stock investors understand that a company’s worth does not always correspond to the price of the commodity it produces.

What matters most is the amount of the commodity produced by the firm over time. If a corporation does not provide what investors expected, the price of its shares might fall.

Why Are Commodities Considered an Inflation Hedge?

Inflation is defined as a widespread increase in prices. Commodities are often used as inputs in industrial operations or are consumed by families and companies. As a consequence, as general prices rise, so should commodity prices. Historically, gold has served as the model inflation-hedging commodity.

How Do Commodities Diversify a Portfolio?

When uncorrelated hazardous assets are introduced to a portfolio, it diversifies. Commodities may offer some diversity since they have low or negative correlations with stocks and other asset classes on average.

What Are Hard vs. Soft Commodities?

Hard commodities are often those that are mined or extracted from the ground. Metals, minerals, and petroleum products are examples of them. Soft commodities, on the other hand, are those that can be cultivated, such as agricultural goods.

What Percentage of My Portfolio Should Be in Commodities?

Experts propose allocating 5-10% of a portfolio to a commodity mix. Those who have a lower risk tolerance may want to consider a lesser allocation.

The Bottom Line

During inflationary periods, many investors gravitate to asset classes such as real-return bonds and commodities (as well as maybe overseas bonds and real estate) to safeguard their capital’s buying power. Investors strive to offer several degrees of downside protection and upside potential by including these varied asset types into their portfolios. What matters is that the investor establishes the greatest correlation of returns that they would allow across asset classes and that they choose their asset classes prudently.

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