Investing in commodities

14 February 2018

Commodities are often dubbed ‘the fifth asset class’ after cash, bonds, shares and property and are widely considered to be part of the ‘alternative investments’ set.

The value of investments can fall as well as rise and you could get back less than you invest. If you’re not sure about investing, seek independent advice.

What you’ll learn:

  • What commodities are.
  • What tends to influence commodity prices.
  • How you can invest and the risks associated with this asset class.

A weakening dollar combined with US corporate tax cuts at the beginning of the year helped boost the price of oil and other dollar-denominated commodities.

Commodities are typically considered to be raw materials, and are divided into four groups – energy, precious metals, industrial metals and agricultural commodities.

When the dollar is weaker this often boosts investor demand for raw materials priced in the American currency, which pushes up prices.

The Bloomberg Commodity Index, a broadly diversified index that tracks the commodities markets, reached an 11-month high in January 2018, with improving global economic growth also helping apply upward pressure.1

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

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.

The basics

Commodities are essentially physical assets. Those in the energy sector include oil and natural gas, while gold, platinum and silver fall under the precious metals banner. There are also so-called ‘soft’ commodities, which are usually things which are grown rather than mined, such as cocoa beans, sugar and wheat.

Many investors opt to include commodities as part of a diversified portfolio, often because of the way they are largely uncorrelated to other assets. If share prices fall, for example, it doesn’t necessarily mean that commodity prices will follow, although of course this isn’t always the case.

Historically commodities have also provided investors with some protection against inflation, as they tend to rise in line with the overall costs of living. For example, when fuel prices start rising on the UK’s forecourts, it’s usually as a result of steeper oil costs.

However, any would-be investors need to bear in mind that commodities aren’t for the faint-hearted as they can endure very significant price swings.

In addition, bear in mind that cash savings pay interest, while shares often pay an income in the form of dividends, commodities themselves don’t pay a yield or income. However, some funds that invest in this asset as part of a pooled portfolio may aim to pay investors a form of income.

What influences returns?

The chief influence on commodity values is supply and demand constraints. If a particular resource is in plentiful supply its price typically tends to fall, whereas when stockpiles are tight, prices tend to rise.

For example, precious metals such as platinum and gold are more expensive than industrial metals because they’re in much shorter supply. Their price, and those of other commodities, rises when demand for them grows, and falls when demand slows.

For example, bad weather can have a significant impact on demand for agricultural commodities, with prices tending to soar if harvests yield less than hoped for.

But political and global macroeconomic factors can be a key influence on commodity prices too.

Some perceive gold as a ‘safe haven’ asset, or a store of value. When it was announced on 24 June 2016 that the UK had voted in favour of Brexit, the price of the yellow metal enjoyed its biggest jump since 2008 amid a climate of uncertainty. Gold subsequently reached a one-and-a-half year high in the first month of 2018, buoyed by the lower dollar.2

The price of oil is also widely viewed as a barometer of the global macroeconomic backdrop. In June 2014 for example, Brent crude, an international oil benchmark, was being sold for $115 a barrel. But by January 2016, the price had nosedived to less than $30 a barrel, in the wake of soaring oil production from OPEC nations - the international producers’ cartel.3 In January 2018, the price rose above $70 per barrel for the first time since 2014, helped by OPEC and Russia extending production cuts.4 However, it fell back to a seven-week low in the first week of February, after Iran announced plans to increase oil production and US crude output reached record highs.5

How to invest

Investing in commodities isn’t for the faint-hearted. However, if you’re prepared to accept the risk that you could lose the capital you invest, there are a number of ways to access the asset class. But always remember that any sensible investment strategy should hold a suitably diversified spread of assets.

There are basically three ways to invest in commodities. You can buy directly, buy shares in commodity companies, or through a pooled investment such as a fund, investment trust or Exchange Traded Product.

In the case of some commodities, you can take a direct approach – for instance with gold you can buy bullion bars or coins but then you need to consider how you can store them safely, and this can be expensive.

Many investors instead tend to opt for a specialist fund, investment trust or exchange traded commodity (ETC). You can, for example, invest in a physical gold ETC, which will provide you with exposure to the precious metal by tracking its price.

There’s also a reasonably large selection of actively managed funds that focus on the commodity sector. Some will invest in physical commodities as well as mining firms and companies involved in the commodities industry.

While the shares of mining, oil and gas companies and other firms in this space should do well if commodities perform robustly, their success depends more on how well they’re doing as a firm and how much profit they’re making, rather than how underlying commodity prices are doing.

As is the case with all investments the value of commodities can go down as well as up, so you could lose money. In addition, this asset class can be highly volatile and would-be investors need to be prepared for what can be a potentially very bumpy ride because while the gains can be significant, the falls can be even steeper and you may get back less than you invested.

Past performance is not a reliable indicator of future performance.

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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.

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