How to Invest in Commodities

In addition to stocks and bonds, some investors also invest in commodities. This guide encompasses the most important information and explains a number of instruments that you can use to invest in commodities.

What are commodities?

Commodities are raw materials that are either consumed without further processing, or provide the base materials from which industrial goods are made. Many commodities are vital for the manufacturing of numerous products, and thus have a major impact on the economy. Some examples of commodities are:

• Industrial metals like lead, iron, and copper.
• Precious metals like gold, silver, platinum, and palladium.
• Crude oil.
• Natural gas.
• Agricultural produce like grains, coffee, and cocoa.

Major commodities exchanges include the Chicago Mercantile Exchange (CME) and the London Metal Exchange (LME), among others.

Why should I invest in commodities?

There are a number of reasons why a person may choose to invest in commodities. Some examples are:

• Economic importance: Commodities have been important to mankind since the dawn of history. They form the basis of an economy, and play a key role in many industries. It is unlikely that the importance of commodities will change significantly in the future.
• Diversification: Compared to stocks and bonds, commodities have a relatively niche existence in most investment portfolios. Targeted investments in commodities can help you diversify your investment portfolio. 
• Protection from inflation: Because inflation results in the prices of raw materials going up, commodities are often considered to be a useful asset class for hedging against inflation. Rare metals like gold, for example, have long been considered to be a safe haven in times of crisis.

How can I invest in commodities?

There are many different ways to invest in commodities. Which of these makes the most sense depends on many different factors - primarily, it depends on which raw material you want to invest in.

• Buy physical commodities

Buying actual, physical raw materials is not a realistic option for most private investors. For many commodities, markets can be very difficult to access, and transportation and storage can be complicated and expensive. But there are certain commodities, such as precious metals, that are an exception to this rule because buying, storing, and selling these materials is relatively simple. You can find detailed information in the moneyland.ch guides to investing in gold, silver, platinum, and palladium.

• Commodities ETFs

Using exchange-traded funds (ETFs) is one of the simplest alternatives to buying physical commodities yourself. These investment funds, which are listed on stock exchanges, can be used to invest in many different commodities without having to buy and hold physical goods. ETFs normally replicate indexes which, in turn, track the prices of commodities. It is important to understand that when you buy shares in an ETF, you are investing in the fund, and not in actual raw materials. The fund invests the money. In most cases, this is done using futures, but there are exceptions to this rule. Some precious metal ETFs, for example, hold actual precious metal instead of futures contracts.

Simplicity is the biggest advantage of using ETFs to invest in commodities. Many commodities ETFs are also relatively diversified, replicating indexes that track a whole basket of different commodities. Using an ETF that covers a broad range of commodities is less risky than investing in just one or two commodities, as it is unlikely that the prices of all commodities would drop at the same time.

ETFs charge ongoing fees that are deducted directly from the fund’s investment capital. The cost of using an ETF is shown as its total expense ratio (TER). In addition to the TER charged by the ETF itself, your stockbroker may charge you brokerage fees for buying and selling your ETF shares, and custody fees for holding them. Brokerage and custody fees vary between stockbrokers. You can use the interactive stockbroker comparison to compare the costs based on your specific needs.

• ETCs

Exchange-traded commodities (ETCs) can be used to invest in specific commodities. ETCs replicate the performance of futures for a specific commodity, much like ETFs. The difference between an ETC and an ETF is that an ETC is a debt claim against the company that issues it, while an ETF is a fund with segregated assets. The chance of losing money if the issuing company goes bankrupt is higher for ETCs than for ETFs.

Like ETFs, ETCs are traded on stock exchanges, and they can be bought and sold during trading hours. The ETC’s issuer charges ongoing fees, which are shown as the TER. Your stockbroker may charge you brokerage fees when you buy and sell ETCs.

• Futures and CFDs

Financial derivatives like futures and contracts for difference (CFDs) can be used to speculate on future developments in the prices of commodities without having to buy physical goods. While there are differences between futures and CFDs in terms of the way they work, both of these are effectively betting instruments, and both can result in heavy losses if markets turn against you. Because of the high risk of loss, futures and CFDs are not suitable for inexperienced investors.

• Stocks and stock ETFs

Many companies are involved in the mining, processing, and marketing of raw materials. Investing in these companies can be an indirect way to participate in commodities markets. Glencore, which is headquartered in Switzerland but listed on the London Stock Exchange, is one example of a company that specialized in raw materials.

It is important to bear in mind that investing in just a few individual companies exposes you to a high risk of loss. Buying shares in a stock ETF that, in turn, invests in a long list of companies in the commodities sector, is a simple way to reduce the risk by spreading your investment across many different companies. One example of an ETF that invests in the stocks of companies in the commodities sector is the Fineco AM MSCI World Metals and Mining UCITS ETF EUR Acc (ISIN: IE000EE3Q489), which invests in companies in the metallurgical and mining sectors. It is worth noting, though, that these sectors make up just a small part of the entire commodities industry.

Are there any risks and disadvantages?

As with other asset classes, investing in commodities comes with a risk of loss. It is important to understand that before you invest. There are also certain additional risks that are specific to commodities investments:

• Complexity: The trade in raw materials is multifaceted and complex. There are numerous factors that can influence the prices of raw materials, and each commodity has its own set of influencing factors. The economic situation, the political landscape, inflation rates, inflation predictions, geographic factors, and the weather are just some of the things that can affect the prices of commodities. The complexity of commodities markets can be a major hurdle for investors who are not familiar with these markets.
• Volatility: If you have a difficult time dealing with price fluctuations, then commodities probably are not the right asset class for you because markets for raw materials are notoriously volatile. Crude oil is a good example of an extremely volatile commodity which is strongly affected by geopolitical tensions. But metals like copper and silver, which are widely used in industry, can also experience sharp price fluctuations depending on the economic situation and industrial demand.  
• Ethical concerns: Many companies in the raw materials sector - such as mining companies - are frequently criticized for negative impacts on the environment and for the exploitation of developing countries. There is also growing criticism that speculation with agricultural commodities can push up the prices of basic foodstuffs, with the populations of poorer countries being especially hard hit. While gaining a thorough knowledge of what you are investing in is always advisable, it is exceptionally important in the case of commodities.

How profitable are commodities investments?

There is no way to answer that question precisely. Firstly, there is no way to predict how prices will develop in the future. Secondly, the commodities asset class is extremely diverse, and the prices of different raw materials have developed very differently from one another. The potential performance depends largely on which commodities you invest in.

A comparison between a broadly-diversified commodities ETF and a broadly-diversified global stock ETF that replicated the MSCI World index can provide a point of reference. The comparison shows that the commodities ETF performed better over a five-year term, but the stock ETF had better performance over a 10-year period.

Disclaimer: This article is provided for informational purposes only, and should not be considered as investment advice. The publisher does not accept any liability in connection with this publication.

More on this topic:
Compare Swiss stock brokers now
Stocks, bonds, and other investments: These returns are realistic
How to invest money in Switzerland