Why You Should Rethink Investing in Commodities
The Pros and Cons of Investing in Commodities
Global commodities have tempted investors with spectacular performance at times and exchange-traded funds (ETFs) have made it easier than ever to invest in them. Despite these periods of outperformance, the asset class is a poor investment for most investors and even many professional short-term traders that are exiting the business.
Let’s take a look at some of the major reasons that investors should rethink investing in commodities and then look at when it might make sense.
You Don’t Receive Interest or Dividends
Many stocks pay dividends and most bonds pay interest, but commodities don’t inherently generate any interest or dividends. The value of commodities depends purely on global production, commercial demand, and speculation, whereas a stock represents ownership in a business that typically grows in value over time. For example, gold prices have inflation-adjusted annual real returns of just 0.6 percent compared to 6.7 percent for stocks.
Commodities Are More Difficult to Understand
Most investors are familiar with how the stock market works, but investing in commodities is significantly more complicated. Commodities are primarily traded using derivatives known as futures contracts, where a seller agrees to deliver a commodity to a buyer at a set time and price in the future in exchange for a premium. As a result, the current price of a commodity has little to do with what investors will make on a commodity futures contract.
You Must Pay the Storage, Insurance, and Other Fees
Commodities are physical objects that must be transported, stored, managed, and insured against loss. For example, gold bullion must be held in a vault and insured in case of theft and crops must be insured against loss from adverse weather or wildfires.
These expenses are collectively known as the cost of carry or carrying charge and put downward pressure on an investor’s long-term total returns.
Commodities Aren’t a Great Hedge Over Time
Many investors use commodities as a hedge to reduce portfolio risk since they have a low correlation with other asset classes. The problem is that many commodity indexes are heavily weighted in a handful of commodities—such as crude oil—and many crises where they tend to outperform on a speculative basis are short-lived. In recent times, there has also been a positive correlation between equities and crude oil and Treasuries and gold.
You Might Not Be Able to Sell at a Good Price
Many commodities lack liquidity, especially when they are traded further out on the curve. Futures exchanges deal with these issues by bootstrapping contract values the market closes, which creates large price swings in valuations on marked-to-market portfolios. The lack of liquidity—or liquidity risk—makes it difficult to buy and sell contracts at appropriate prices, which can increase risk and potentially decrease returns.
Some Commodity Markets Are Openly Manipulated
Most investors are aware of the Organization of Petroleum Exporting Countries (OPEC) and its impact on crude oil prices, but there are many other lesser known cartels that dominate the market for commodities like potash and diamonds.
This means that these markets may not be entirely influenced by supply and demand, but rather, the whims of a small group of traders or investors that wishes to keep prices at a certain level.
When Do Commodities Make Sense?
Commodities may be a poor investment for most investors, but there are cases where they make sense. In particular, precious metals like gold may serve as a useful hedge over a short period of time when an investor is concerned about a crisis. Gold prices have a negative correlation of about 0.2 (-0.2) with the S&P 500 index, which means that they tend to rise when equity prices fall, making it a useful short-term hedge against decline.
In some cases, investors may also identify opportunities where commodity prices will move in predictable directions. A good example would be crude oil markets ahead of an OPEC meeting where a production increase or decrease is widely expected.
While prices may have already moved up in anticipation, these events usually lead to volatility that can be profitable for short-term traders or speculative investors.
Finally, commodities can also serve as useful hedges for other investments. A good example is a portfolio that’s highly concentrated in crude oil companies. If the investor wishes to hedge against a decline in crude oil prices, they could use futures contracts to remove commodity-related risks, while still benefiting from company-related risks and rewards.