Commodities: The Portfolio Hedge

Most people picture a trading floor at a futures exchange as a scene of utter chaos, with fierce shouting matches, frantic hand signals, and high-strung traders jockeying to get their orders executed, which is not too far from the truth. These markets are where buyers and sellers come together to trade an ever-expanding list of commodities. That list today includes agricultural goods, metals and petroleum, and products such as financial instruments, foreign currencies, and stock indexes that trade on a commodity exchange.

At the center of this supposed disorder are products that offer a haven of sorts—a hedge against inflation. Because commodities prices typically rise when inflation is accelerating, they offer protection from the effects of inflation. Few assets benefit from rising inflation, particularly unexpected inflation, but commodities usually do. As the demand for goods and services increases, the price of goods and services rises as does the price of the commodities used to produce those goods and services. Futures markets are thus used as continuous auction markets and as clearinghouses for the latest information on supply and demand.

What Are Commodities?

Commodities are goods that are more or less uniform in quality and utility regardless of their source. For instance, when shoppers buy an ear of corn or a bag of wheat flour at a supermarket, most don't pay much attention to where they were grown or milled. Commodity goods are interchangeable, and by that broad definition, a whole host of products where people don't particularly care about the brand could potentially qualify as commodities. Investors tend to take a more specific view, most often referring to a select group of basic goods that are in demand across the globe. Many commodities that investors focus on are raw materials for manufactured finished goods.

Investors break down commodities into two categories: hard and soft. Hard commodities require mining or drilling, such as metals like gold, copper, and aluminum, and energy products like crude oil, natural gas, and unleaded gasoline. Soft commodities refer to things that are grown or ranched, such as corn, wheat, soybeans, and cattle.

Benchmarks for Broad Commodity Investing

Benchmarking your portfolio performance is crucial because it allows you to gauge your risk tolerance and expectations for return. More importantly, benchmarking provides a basis for a comparison of your portfolio performance with the rest of the market.

For commodities, the S&P GSCI Total Return Index is considered a broad commodity index and a good benchmark. It holds all futures contracts for commodities such as oil, wheat, corn, aluminum, live cattle, and gold. The S&P GSCI is a production-weighted index based on the significance of each commodity in the global economy, or the commodities that are produced in greater quantities, so it is a better gauge of their value in the market place similar to the market-cap-weighted indexes for equities. The index is considered more representative of the commodity market compared to similar indexes.

Why Commodities Add Value

Commodities tend to bear a low to negative correlation to traditional asset classes like stocks and bonds. A correlation coefficient is a number between -1 and 1 that measures the degree to which two variables are linearly related. If there is a perfect linear relationship, the correlation coefficient will be 1. A positive correlation means that when one variable has a high (low) value, so does the other. If there is a perfect negative relationship between the two variables, the correlation coefficient will be -1. A negative correlation means that when one variable has a low (high) value, the other will have a high (low) value. A correlation coefficient of 0 means that there is no linear relationship between the variables.

Typically, U.S. equities, whether in the form of stocks or mutual funds, are closely related to each other and tend to have a positive correlation with one another. Commodities, on the other hand, are a bet on unexpected inflation, and they have a low to negative correlation to other asset classes.

Commodities can and have offered superior returns, but they still are one of the more volatile asset classes available. They carry a higher standard deviation (or risk) than most other equity investments. However, by adding commodities to a portfolio of assets that are less volatile, the overall portfolio risk decreases due to the negative correlation.

How Volatile Are Different Commodities

Supply-and-demand dynamics are the main reason commodity prices change. When there's a big harvest of a certain crop, its price usually goes down, while drought conditions can make prices rise from fears that future supplies will be smaller than expected. Similarly, when the weather is cold, demand for natural gas for heating purposes often makes prices rise, while a warm spell during the winter months can depress prices.

Because the supply and demand characteristics change frequently, volatility in commodities tends to be higher than for stocks, bonds, and other types of assets. Some commodities show more stability than others, such as gold, which also serves as a reserve asset for central banks to buffer against volatility. Yet even gold becomes volatile sometimes, and other commodities tend to switch between stable and volatile conditions depending on market dynamics.

The History of Commodity Trading

People have traded various commodity goods for millennia. The earliest formal commodities exchanges are among those in Amsterdam in the 16th century and Osaka, Japan, in the 17th century. Only in the mid-19th century did commodity futures trading begin at the Chicago Board of Trade and the predecessor to what eventually became known as the New York Mercantile Exchange.

Many early commodities trading markets were the result of producers coming together with a common interest. By pooling resources, producers could ensure orderly markets and avoid cutthroat competition. Early on, many commodity trading venues focused on single goods, but over time, these markets aggregated to become broader-based commodities trading markets with a variety of goods in the same place.

How to Invest in Commodities

There are four ways to invest in commodities:

1. Investing directly in the commodity.
2. Using commodity futures contracts to invest.
3. Buying shares of exchange-traded funds (ETFs) that specialize in commodities.
4. Buying shares of stock in companies that produce commodities.

Direct Investment

Investing directly in a commodity requires acquiring it and storing it. Selling a commodity means finding a buyer and handling delivery logistics. This might be doable in the case of metal commodities and bars or coins, but bushels of corn or barrels of crude oil are more complicated.

Futures

Commodity futures contracts offer direct exposure to changes in commodity prices. Certain ETFs also offer commodity exposure. If you would rather invest in the stock market, you can trade stock in companies that produce a given commodity.

Commodity futures contracts require the investor to buy or sell a certain amount of a given commodity at a specific time in the future at a given price. To trade futures, investors require a brokerage account or a stockbroker who offers futures trading.

When prices of a commodity rise, the value of a buyer's contract goes up while the seller suffers a loss. Conversely, when the price of a commodity goes down, the seller of the futures contract profits at the expense of the buyer.

Futures contracts are designed for the major companies in the respective commodity industry. One gold contract could require buying 100 troy ounces of gold, which could be a $150,000 commitment, which is more exposure than the average investor wants in their portfolios.

ETFs

Most individual investors choose ETFs with commodity exposure. Some commodity ETFs buy the physical commodities and then offer shares to investors that represent a certain amount of a particular good.

Some commodity ETFs use futures contracts. However, futures prices take into account the storage costs of a given commodity. Therefore, a commodity that costs a lot to store might not show gains even if the spot price of the commodity itself rises.

Commodities-Related Stocks

Investors can also buy shares of the companies that produce commodities. For example, companies that extract crude oil and natural gas or companies that grow crops and sell them to food producers. Investors in commodity stocks know that a company's value will not necessarily reflect the price of the commodity it produces.

What is most important is how much of the commodity the company produces over time. The price of a stock can plummet if a company does not produce what the investors have anticipated.

The Bottom Line

During inflationary times, many investors look to asset classes like real-return bonds and commodities (and possibly foreign bonds and real estate) to protect the purchasing power of their capital. By adding these diverse asset classes to their portfolios, investors seek to provide multiple degrees of downside protection and upside potential. What is important is that the investor draw the line on the maximum correlation of returns they will accept between their asset classes and that they choose their asset classes wisely.