Many investors like the idea of adding commodities to their portfolios to make them more diversified. Stocks, bonds, and many other popular asset classes often trade in lockstep with each other, making it harder to avoid downturns when conditions on Wall Street deteriorate. Commodities, on the other hand, typically behave in accordance with the supply and demand dynamics of their markets, and with each commodity having its own producers and consumers, you can get greater diversification by being smart about what you pick.
However, commodities investing is a lot different from trading stocks. Commodities are actual tangible things, and when you own them, you have to take on logistics responsibilities to ensure proper storage and maintenance to avoid losses. Fortunately, there are several ways you can invest in commodities, some of which are more practical for certain markets than others.
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1. Own the commodity directly
At first glance, the simplest way to invest in commodities would seem to be just to buy it directly. For instance, if you want to invest in gold, you can buy a gold coin or bar of a certain weight.
The main problem with direct commodity ownership is that it's hard to handle most commodities. Most people don't have anywhere to store 1,000 barrels of oil or 5,000 bushels of corn, and paying for storage facilities can be costly. Only with relatively compact commodities like precious metals does direct ownership work well, and even then, you'll have to pay coin dealers a substantial premium to purchase them. That can be worth it if you intend to hold on to your commodity investment for the long run, but frequent trading isn't a practical option when you own the commodity directly.
2. Owning commodity stocks
Another way to invest in commodities is to own stocks that produce them. For instance, agricultural companies produce crops, while energy companies drill for oil and natural gas, and miners dig for gold and other precious and base metals.
Stocks of companies that produce commodities often track to some extent the movements of the underlying commodity. However, other factors come into play. Issues like a drought that hurts crop yields or an accident that causes major oil spills or mine closures can send the price of a particular commodity stock down sharply even if the price of the commodity itself rises in response. That risk is often worth it in exchange for the potential to enjoy both share-price growth and regular dividends, but commodity stocks don't offer direct exposure to commodity prices.
3. Commodity futures
An alternative to directly owning commodities is to invest in futures contracts. These derivatives involve agreeing to buy or sell commodities at a specified time and price in the future. Futures buyers make money when prices go up, while sellers of futures make money when prices go down.
One problem that futures contracts have is that they usually require large investments. Each futures contract corresponds to a specified amount of the commodity in question, and that amount is often higher than most investors would want. For instance, a typical gold futures contract is for 100 ounces, representing about $130,000 at current prices. Also, some stockbrokers don't offer futures trading, while others require special arrangements that can add complexity to your investing.
4. Commodity ETFs
Exchange-traded funds have gotten quite popular, and you can get exposure to commodities through specialized ETFs that focus on the area. ETFs like SPDR Gold (NYSEMKT: GLD) and iShares Silver (NYSEMKT: SLV) own tons of gold and silver, with each share representing a small portion of that hoard.
Other commodity ETFs offer broader exposure to the entire commodities markets. Some own physical goods, but many use futures contracts to lock in their exposure. As you can see below, results can be volatile, but they do tend to trade independently of stocks, bonds, and other investment assets.
Assets Under Management
PowerShares DB Commodity Index Tracking (NYSEMKT: DBC)
iShares S&P GSCI Commodity-Indexed Trust (NYSEMKT: GSG)
Data sources: fund websites, ETFdb.com.
Be smart with commodities
If you want to invest in commodities, these four methods can be useful in helping you define the exact exposure you want. Whether you pick commodities themselves or the companies that produce and sell them, you can profit if demand for the commodity you pick rises faster than supply can handle.
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