What are commodities?

In the investment world, commodities are essentially the raw materials of other industries: largely metals, minerals and agricultural produce.


Why invest in commodities?

Commodities can provide diversification benefits. Historically, commodity prices and equity prices have been negatively correlated – in other words, when one does well, the other tends to do badly.

However, this seems to have broken down in recent years, as all assets have moved increasingly in line with one another.

This could be a sign of stress in the global economy, which may mean that the negative correlation and the diversification benefits return once the years of crisis pass.

Some commodities can also offer very high capital returns over long periods of time. However, as a volatile asset class, they can also lead to heavy losses.


Gold

Many top-class professionals and retail investors regard gold as a store of value that can protect a portfolio in times of inflation.

However, the historical record is not so clear on this, and investors need to be aware that this is only one point of view.

Some critics of gold, such as Warren Buffett, the most famous investor in the world, point out that it is fundamentally unproductive, cannot pay out a dividend and ultimately is supported by sentiment rather than by any economic fundamentals.

The same holds for silver as for gold, except there are more industrial uses for silver that can affect the price more substantially.

Oil

The price of oil is highly sensitive to the world economy, being the basis for the essential fuels to modern life.

This makes it extremely volatile, both to the upside and the downside. Investing in it is probably best left to the professionals, but you can buy ETFs that track it if you want to take on more risk.

There are other metals and minerals that are traded largely by professionals and often through financial instruments that aren’t realistic options for retail investors.


How to invest?

ETFs allow investors to invest in or trade an asset without actually owning it, which would be costly and impractical in most cases: few of us have the resources or inclination to take delivery of barrels of crude oil.

For more details on ETFs, see here.

For a more diverse exposure to commodities, investors are probably better off going through funds.

However, these hold the shares of companies that mine or transport the commodities rather than the materials themselves.

This means that the funds are more correlated to equity markets than the underlying commodities, which needs to be borne in mind if your purpose in investing in the sector is diversification.

It is especially important to do your homework if you are thinking about investing in commodities, as not only are they highly volatile, but the factors that move prices are highly contentious.