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How to Add Commodities to an Investment Portfolio

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I have previously stated that commodity investments aren’t a great strategy for beginning investors. The high volatility and ease of access to leverage can easily lead to heavy losses beyond those of the initial investment. However, for those who do wish to gain exposure to commodities in their portfolio, here are a list of mechanisms that you can utilise.

Commodity Trading Mechanisms

Direct Commodity Ownership: Certain commodities (typically the non-perishable type) lend themselves to being directly owned. Oil, gas, coffee, pork bellies and frozen concentrated orange juice (FCOJ) are examples of perishable commodities that would be difficult to personally store and transact. Precious metals such as gold, silver and platinum are good examples of commodities where direct ownership makes sense. The simplest mechanism is to obtain gold and silver coins, e.g. UK gold Sovereigns, South African Kruggerand or gold/silver American Eagles. One can also store bullion (“ingots” or bars) in the form of gold, silver, platinum, copper or nickel at a specialist vault. The storage of such commodities will likely be subject to a cost of carry, which is a continual payment for holding the commodity owed to the storage firm. Direct ownership makes less sense in today’s society, especially with the advent of sophisticated financial products such as Exchange-Traded Funds (ETFs) and Spread Betting.

Exchange Traded Funds (ETFs): ETFs are a relatively new trading mechanism, where units of investment funds are bought and sold on a stock exchange in an identical manner to traditional equities. The underlying funds themselves may have a remit to invest in almost any asset class. Thus, individual investors can gain access to alternative asset investments that may otherwise have been unavailable. Many ETFs support commodity investments, so one straightforward mechanism to gain exposure to commodities is to purchase ETFs that track their respective spot prices. Hence you will find spot gold, spot oil, spot gas and even spot pork belly ETFs. In order to purchase these ETFs, one can contact a broker in exactly the same manner as investing with traditional equities and thus diversify a portfolio with minimal difficulty.

Equity Ownership in Commodity Firms: A more “traditional” method of investing in commodities, albeit indirectly, is to purchase equity directly in firms specialising in commodity retrieval, processing or storage. Thus you might look into equities (either public or private) that have an interest in, e.g. mining, for precious metals; energy, for oil and gas extraction and refinement; agriculture, for livestock and grain processing. The major difference when investing in a firm, as opposed to the commodity directly, is that the firm may be significantly more illiquid than the underlying commodity you wish to gain exposure to. Further, you are investing in a business and thus will exposed to the risk of its balance sheet and income statement, not just the fluctuations of the commodity price.

Commodity Derivatives: Commodity derivatives are an extremely powerful tool for gaining large exposure to commodities as an investment. However, they are also extremely dangerous as they allow significant margin (i.e. leveraged control) and can are highly volatile. The two main mechanisms utilised for commodity derivatives are commodity futures and commodity options. The former allows substantial leverage on underlying commodities prices, but also the promise of a high return. Professional commodity futures speculation is the domain of the Commodity Trading Advisor (CTA) and not often a retail investor. Commodity options are similar in that high leverage can be achieved, although with the correct structure of option, the downside risk can be limited. Options prices are subject to their own market dynamics so I would not recommend trading commodity options to the beginning investor.

Spread Betting: Spread Betting is a relatively new technique, available in the UK to consumers, that allows leveraged bets with the spread betting firm on almost any liquid underlying asset class. In particular, spread betting allows exposure to foreign exchange, fixed income, commodities and equities, among other asset classes. The benefits of spread betting include access to leverage as well as full income and capital gains tax exemption. Fundamentally, spread betting is not too dissimilar to working with futures, as the spread betting firm will be hedging their positions with these derivatives anyway. I would not recommend spread betting to the beginning investor as it is easy to lose all of your initial capital and substantially more, if not careful.

A Small Warning on Adding Commodities to a Portfolio

Commodities have traditionally been added to a wider portfolio in order to increase diversification. Further, commodities have historically had weak correlations with some other asset classes and so could be “depended upon” to provide a safe(r) haven in times of higher volatility elsewhere in the market. In practice, due to the ever-increasing interdependence of global financial markets, asset classes that are normally uncorrelated can rapidly become correlated and all head in the same direction (often down), during times of adverse market conditions. Thus one should be very wary about relying on commodities as an uncorrelated diversification mechanism against a traditional equity/fixed income portfolio.

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