Commodities are raw materials like oil, wheat, silver and gold. Typically, commodities are used to produce other things like gasoline, bread, jewelry and so forth. For an investor, commodities present an opportunity to invest in materials some countries produce and others consume. The laws of supply and demand at work.
Manufacturers tend to buy commodities when they need them – on the “spot market.” Speculators buy and sell commodity options and futures contracts.
Types of Commodity Investments
Securities that are linked to commodities are dependent on the price of the commodity at any given time. A commodity-linked oil bond, for example, is indexed to movements of an oil index. Commodity derivatives include swaps, futures and forwards that are both exchange-traded and over-the-counter.
If you take a long position in a futures contract for a commodity and then purchase that amount in T-bills, your return comes from interest on your T-bill position and movement of the futures price. This is known as collateralized commodity futures.
Why Invest In Commodities, Commodity Derivatives Or Commodity-linked Securities
Among the benefits you can gain by investing in commodities include having a hedge against inflation. Commodity prices benefit from unexpected inflation while stocks and bonds might suffer. The inflation advantage is most efficient when you directly invest in commodities as opposed to other tactics.
Investor interest in commodities has grown in recent years mostly due to a rise in commodity prices overall. This has created an opportunity for better performance than from traditional assets such as stocks and bonds. You can thank China and other emerging economies for the rise in commodity prices.
Portfolio diversification is another benefit of holding commodities. With commodities you are exposing part of your portfolio to things like the weather, as opposed to the types of things that affect stock and bond markets. In other words, you are diversifying your risk.
Forms of Commodity Investing
Investing in commodities can be either passive or active. Passive investing is part of a strategy investors use to achieve portfolio diversification. This is due to the fact commodities tend to rise during periods of inflation, in contrast to stocks. Investing in high-quality index-based commodity funds carries smaller risk than investing in individual commodities, making it a reasonably smart way to invest in commodities, even if you don’t know a lot about the sector.
Active investing in commodities can provide excellent performance results for those who know and understand the market. This is especially true in periods of economic growth when commodities when commodities are in strong demand. Commodity prices tend to move quickly in reaction to economic conditions on the ground and this requires active, closely managed monitoring by the investor.