Commodity prices, such as gold, wheat, oil, and energy, are soaring right now, naturally increasing investor interest.
International supply-chain difficulties have resulted in global shortages, unusual weather has impacted crop production in important agricultural regions, and inflation has created an appealing hedging option out of real assets like commodities.
With commodities in your portfolio, you can gain exposure to many resources, which reduces risk and diversifies your investment plan, and you can even protect yourself from inflation.
Commodities are one of the most popular asset groups for investors, alongside stocks, bonds, and real estate. Formerly, private investors have had a difficult time gaining direct access to this type of investment, but exposure has become easier than ever before because of the exchange-traded fund (ETF) phenomenon.
- Commodities Investing – An Overview
- Commodity ETFs
- Contango and Backwardation
- Advantages of Commodity ETFs
- Disadvantages of Commodity ETFs
- In Summary
Commodities Investing – An Overview
The buying and selling of raw materials is known as commodities trading. It occasionally involves trading the product physically, also known as the ‘spot market’ – however, more often than not it involves trading futures contracts on the ‘futures market’.
Futures contracts are contracts that bind the parties to an agreement to buy or sell an asset at a particular price and date in the future. Regardless of the prevailing market price at the end date, the buyer or seller must purchase or sell the underlying asset at the predetermined price. They’re frequently utilized as a risk management strategy by key industrial players in the event that prices rise or fall.
Commodities are often classified into two categories: hard and soft. Hard commodities are normally found by mining and drilling, while soft commodities are typically cultivated or grazed. Commodities can then be further subcategorized into four groups:
- Energy products are considered hard commodities. Crude oil, natural gas, coal, unleaded gasoline, and ethanol are among them.
- Metals are another hard commodity. Precious metals like gold and silver, as well as industrial metals like copper, aluminium, and palladium, are among them.
- Soft goods include agricultural products like wheat, corn, coffee, soybeans, timber, and cotton.
- Meat and livestock are also soft commodities. These include such items as live cattle, meat, and milk, as well as others.
Traders of commodities make bets on the direction in which the price of the commodity will change. You buy futures or ‘go long’ if you believe the price of a commodity will rise. You sell futures or ‘go short’ if you believe the price will fall.
Changes in supply and demand cause commodity prices to swing dramatically. When a large harvest of a particular crop occurs, for instance, the price of that crop normally drops. However, prices will often rise during a drought due to concerns that supplies will be reduced.
Some commodities, such as gold – which also acts as a reserve asset for central banks – are very stable, but overall, commodities are much more volatile than bonds or equities.
Commodities are attractive to certain investors who want to diversify their portfolios. This is because commodities and equities typically have a negative correlation (meaning their prices move in opposite directions) or a low correlation (their prices do not move in lockstep).
Oil and stocks, for instance, have a negative correlation. As a result, rising oil costs are a sign that the markets are down, and vice versa.
Commodities are hence a common inflation and stock market hedge. During bad market conditions, many investors will gravitate to gold, and when inflation is high, commodities prices often rise with it.
Unless you’re equipped to trade commodity futures directly, the most convenient way to invest in the asset class is through funds, like exchange-traded funds. ETFs are likely the simplest and most straightforward method of gaining commodity exposure.
Commodity funds in the United States, for instance, have returned an average of 17% year to date, while stocks and bonds have both declined. Commodities ETFs have already witnessed billions in net asset inflows this year.
ETFs allow investors to gain exposure to a large basket of commodities. These ETFs will generally obtain exposure through futures contracts or asset-backed contracts that track the performance of a specific commodity, which means the investor will not “literally” hold the underlying assets.
You can invest in physical materials, commodity stocks, futures contracts, or a combination of the three. For instance, investors who want exposure to oil can consider the United States Oil Fund LP ETF (USO), or those who are bullish on gold can consider the SPDR Gold Trust ETF (GLD).
Additionally, those wanting exposure to a broad range of commodities might invest in the iShares S&P Commodity-Indexed Trust (GSG), which follows the S&P GSCI index.
An investor can choose from a variety of commodity indices. The Bloomberg Commodity Index is one of the most renowned. This index follows the performance of 23 distinct commodities, which are weighted according to their economic strength. To guarantee that the index remains diverse, each commodity is capped at 15%, and each commodity “segment” is capped at 33%.
Note: Commodity ETFs typically invest in short-term contracts in order to keep as near to the spot price as they can. To prevent having to deliver the commodities physically, the ETF then sells the futures again just before expiration and then moves to the next contract.
If a fund buys front-month contracts, it receives exposure to the futures curve’s earliest contract. That is to say, the one with the shortest maturation period. This strategy is intended to provide the most exposure to the commodity’s spot price. The ETF will “roll” onto a new contract when the front-month contract approaches maturity, which will become the next front-month contract.
On the other hand, some ETFs, e.g., those that track the Optimised Roll Commodity Total Return Index, may seek to increase investor returns by employing a more flexible and dynamic strategy. This particular index selects the futures contract with the best possible ‘roll yield’ on the futures curve.
Contango and Backwardation
In order to understand roll yield, one needs to be familiar with the terms ‘contango’ and ‘backwardation.’ The maturity of a futures contract, or how near it is to its expiration date, decides its price. The longer a contract is left till it expires, the more expensive it becomes. This is referred to as ‘contango.’ However, in some instances, longer-dated contracts can be less expensive than shorter-dated contracts, and this phenomenon is known as ‘backwardation.’
The ‘roll yield’ is determined by whether the market is in contango or backwardation. The phrases contango and backwardation are used to describe the forward curve’s structure. A contango market is when the forward price of the futures contract is greater than the spot price.
When a market is in backwardation, the futures contract’s forward price is lower than the spot price, meaning the investor will get a better deal on their shorter-term, expiring contract than they would on the longer-term successor. This gives the investor a profit or a ‘positive roll yield.’
The term ‘optimized roll’ refers to the index’s approach to maximizing positive roll yield while minimizing negative roll yield.
Note: Because futures-based commodity ETFs must buy or sell large numbers of futures contracts at predictable periods, they run the risk of affecting futures prices themselves. Traders may bid up or down in anticipation of ETF trading orders, putting the ETFs at the mercy of traders.
Advantages of Commodity ETFs
- Commodity ETFs enable you to invest without having to take actual possession of the assets.
- Simplicity. Without an ETF, you’d have to buy commodities futures individually or invest in linked derivatives or firms.
- Every commodity on the market is represented by an ETF. There is therefore an abundance of choice and excellent opportunity for diversifying your portfolio.
- Commissions and management fees will be cheaper.
- Commodity prices are volatile, but ETFs can help mitigate some of the risks.
- Potential for return. Increased demand due to huge global infrastructure projects has had a significant impact on commodity prices in recent years. Commodity price increases have had a beneficial impact on the stocks of companies in connected industries in general.
- Due to their volatile nature, they are a good hedge against inflation.
Disadvantages of Commodity ETFs
- Commodity funds may not move in sync with the underlying commodity’s price.
- Commodity prices can be extremely volatile, and world events, economic conditions, import bans, and government regulations can all have an impact on their prices. There’s a danger that your investment will depreciate in value.
- While commodity funds can help with diversification, they are deemed non-diversified since they invest a large number of their assets in a small number of individual securities that are typically focused in one or two industries.
Commodity exposure is considered necessary for a well-balanced portfolio. ETFs offer a variety of ways for investors to incorporate precious metals, natural resources, and agriculture into their portfolios while minimizing risk.
A lot of investors buy commodity ETFs to protect themselves against inflation or rising commodity prices, and many find their convenience of trading to be appealing. However, commodity ETFs do have a number of significant disadvantages, which investors should be aware of.
Before you trade any commodity ETF, make sure you do your homework. Understand supply and demand dynamics. Keep track of the price of certain resources, such as oil and coal, and keep an eye on how some of the most popular ETFs respond to market conditions.
Commodity trading is a high-reward, high-risk venture. ETFs are an excellent option for those people wanting to invest in commodities for the long term.
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