Why consider commodities?

What you’ll learn:

• That commodities usually behave differently to shares and bonds.
  
• How they can be used to provide investment diversification – and protection against inflation.
  
• Why most investors do not hold them as physical assets.
  

Investing in shares can seem rather impersonal when all you have to look at is a bit of paper (or more likely an electronic record) that tells you that you own a tiny piece of a company. If that company goes bust, you have nothing to show for it.

If you invest in commodities – raw materials that range from metals (both precious and industrial), energy sources (oil and coal) and agricultural goods (such as coffee and wheat) – you have a share in something physical that you can theoretically touch and smell.

But like shares, the value of these tangible assets goes up and down depending on demand, good and bad weather, political or economic crises or other influences on supply.

Since not all commodities are the same their values don’t rise and fall together either. Each can be volatile and therefore risky. The one thing they have in common is these raw materials don’t pay interest or dividends, unlike bonds and many shares.

When the coronavirus crisis hit stock markets in spring 2020, oil prices collapsed along with industrial metals such as copper as the brakes were slammed on global economic activity.

Agricultural commodities weren’t hit as hard, though there were exceptions. A strong US nut harvest meant prices fell, according to reports on Bloomberg news¹.

Precious metal prices by contrast rose strongly in the wake of the crisis. Luke Pearce, Investment Strategist at Barclays says these metals can come into their own in such a situation. He says: "Gold is a particularly popular store of value in troubled times with investors often putting a high price on the yellow metal when yields from other assets fall. With bond yields hovering around all-time lows, and central banks around the world committing to keep interest rates on hold, the perceived opportunity cost of holding gold is low for many investors."

In late 2020, when hopes of economic recovery were buoyed by the development of a trio of Covid-19 vaccines the prices of many other commodities started to recover strongly, including oil and industrial metals such as copper. The latter is often seen as a barometer of economic optimism because of its importance in manufacturing and infrastructure development².

Why consider commodities?

Barclays’ Luke Pearce says there are two main reasons to think about including commodities in a portfolio. He says: "They can add diversification and also act as protection against future inflation."

1. As a means of diversification

Commodities typically have low correlation to other types of assets, such as shares and bonds. Pearce says: "This means that commodities may perform differently at times of market volatility, potentially helping to offset losses from other investments."

If share prices fall, then hopefully commodity prices won’t go in the same direction, although this cannot be guaranteed. Remember that investments can fall as well as rise, and some commodities are considered among the riskier asset classes as they are generally more volatile than other investments. You may get back less than you invested. Past performance is not a guide to future performance.

2. As a hedge against inflation

Including commodities in your portfolio may help you weather future inflation. Commodities have in the past performed well during inflationary periods even when shares and bonds fell in value. The rationale is that when demand for goods and services increases, so do prices (causing inflation) and so do the prices of the commodities used to produce them.

By 2020 inflation had been running at low levels for several decades, which meant the price of commodities on average performed weakly. But with hopes of global economic recovery post coronavirus, intervention by Governments and central banks to stimulate economies and signs in late 2020 that the US central bank, the Federal Reserve, was preparing to make its inflation targets more flexible, inflation could start to rise again. This could provide an argument for holding commodities as a hedge against rising prices.

But remember as with all investments commodities can rise and fall in value. This asset class can be highly volatile and would-be investors need to be prepared for what can be a potentially bumpy ride because while the gains can be significant, the falls can be even steeper and you may get back less than you invested or even lose all your money.

How to hold commodities

Few people invest in commodities as a physical asset – and even if they do (perhaps they have a few gold bullion bars), there are storage costs and insurance to consider. Not many investors have the space to store a barrel of crude oil or keep fresh a one-ton sack of coffee beans (a standard bag size for exporting beans³).

So instead most investors usually get their exposure via a fund or Exchange Traded Commodity (ETC) that in turn invests in these tangible assets. Even then the fund managers don’t always buy the real thing. Instead they might purchase the shares of companies that operate in a particular commodity market, such as oil or mining. More likely they will purchase ‘derivatives’ called futures. This is in effect a ‘promise to buy’ the commodity at a set price in the future.

Barclays’ Luke Pearce says: "As the date of expiry comes nearer you can roll over the future so you never actually take delivery of the commodity."

You might wonder how to decide what type of commodity or what proportion to invest in commodities if any. To give you an idea, Barclays experts look at specialist indices for guidance. One of these is Bloomberg Commodities Total Return Index. This tracks a basket of 20 or so commodities, including gold, crude oil, copper and corn. Our experts tend to allocate no more than a single or low double digit percentage to a portfolio, depending on their overall outlook for commodities.

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The value of investments can fall as well as rise. You may get back less than you invest. Tax rules can change and their effects on you will depend on your individual circumstances.