If you want to invest in commodities without being exposed directly to the kinds of geopolitical events that can introduce instability and volatility into the commodities market, you might want to think about putting your money into commodity stocks instead.
These offer indirect exposure to the assets that underpin the commodities sector. As part of a risk-averse portfolio, they can offer better rates of return, compared with being directly exposed to the commodities themselves.
Purchasing commodities directly can also carry additional costs; few investors ever intend to take delivery of the commodities they buy for investment purposes, but in some circumstances you could be faced with costs for storage or the need to dispose of contracts below market value in order to avoid taking delivery.
Why buy commodities directly?
Buying commodities directly is part of an industrial strategy to gain ownership of a valuable commodity at present-day prices, in order to avoid paying more for it later.
For investors, buying commodities now is a gamble on prices going up in the near to mid-future, at which point the intention is usually to sell the commodity on to an industrial buyer who actually wants to take delivery.
About a third of global investment in commodities takes this direct physical form. For the remaining two thirds, transaction volumes and value arise from indirect investment into commodities.
Why buy commodities indirectly?
Investing indirectly in commodities allows investors to tap into shifts in supply and demand. Again it is essentially a gamble that supply will drop, demand will rise, or both.
If the net balance shifts towards greater demand and mining companies or refineries are unable to meet that demand, prices are likely to rise, leading to positive gains for those who invest in the relevant commodity indirectly.
This is typically a medium to long-term strategy, although in certain circumstances a severely undervalued commodity can reap short-term returns as it returns quickly to its full market value.
An example of this is when supplies are interrupted due to a political event or natural disaster, which can leave industrial buyers scrambling to snap up whatever supplies they can get, often at a price that is inflated substantially in the short term.
Investing via commodity ETFs
Exchange-Traded Funds, or ETFs, have become increasingly popular investment vehicles in recent years.
They typically track a sector or index and offer a relatively hands-free way to invest with good diversification and risk mitigation.
Investing in a commodities ETF can allow you to buy into an entire sector of mining companies and commodity suppliers.
With lower total transaction fees and less admin than buying into individual stocks in different companies, you can get exposure to companies based all over the world, helping to mitigate against the isolated risks of natural disasters and political upheavals mentioned above.
At the same time, if those kinds of events lead to rapid price rises, your ETF is likely to have some exposure to those gains in value too.
You perhaps won’t get 100% of those gains as you would if you invested in the specific stock yourself, but you also have broader coverage so wherever value arises, you’re in a good position to make some gains from it.
If you’re particularly impressed by a specific company working in the commodities sector, buying into commodity stocks is an option.
The isolated risks are greater and if you spread your investment across many different stocks to mitigate this risk, you could face higher transaction fees overall compared with a single buy into an ETF.
But by buying into the companies producing the commodities, rather than gambling on future supply contracts, you also avoid the risk of holding a contract that is nearing expiry or having to take delivery of a physical commodity that you have to sell off at a later date.
How to get into commodities
There are a few factors to consider when buying into commodities for the first time.
The first is what you want to buy. The obvious options are precious metals like gold, as well as major commodities like oil, both of which generally offer positive returns over the medium to long-term.
However, the commodities sector is vast, encompassing ‘hard commodities’ that are mined from the earth, and ‘soft commodities’ that can be grown – and therefore are renewable.
If you’re environmentally minded, you might want to focus more on renewable commodities, especially those that are responsibly farmed.
There are reputational benefits to doing so at a time when consumers worldwide are becoming increasingly focused on the environmental impact of industrial activity, and if you are investing for the long term you might expect this to have a knock-on effect on the value of your investments as we move through the 2020s.
But if you’re driven primarily by value, it’s also worth remembering that a non-renewable resource is much more likely to be in tight supply at a time of high demand.
Try to establish a fair estimate of market value, and of the direction of the market for the commodity you plan to invest in.
If commodity ETFs sound appealing, remember that there are plenty of options even just within that part of the market, including ETFs focused on emerging markets or other specific geographies, specific types of commodity, or eco-conscious operators.
Types of mineral commodity
Mineral stocks allow you to buy into the value of desirable substances that have not yet been mined out of the ground, but whose location and approximate details are known.
These fall into several categories:
- Inferred minerals offer an approximate estimate of quantity and quality based on relatively minimal sampling and geological exploration.
- Indicated minerals are detected in greater detail and may have been explored enough for mining activity to be planned and nearing commencement.
- Measured minerals have been fully explored so that the quantity estimates and quality grades are most likely to be correct when mining begins.
The different categories give investors different levels of confidence when buying into newly discovered mineral deposits.
If you plan to buy into mineral discoveries where mining has not yet begun, you might want to limit your investments to jurisdictions where these categories are tightly regulated by the government, so you have even more confidence about the level of risk you face.
When commodities go the other way
Not all commodities move in the same direction as the wider market. That’s one reason why gold is so popular.
When other metals go down in price, gold often goes up. This is a consequence of its more complicated exposure to investment from different sources.
Gold has industrial applications in electronic circuitry, but it also has sentimental value and aesthetic appeal in jewellery.
For investors, gold coins, bars and bullion are all about weight, while even the global central banks use the precious metal as a physical representation of capital.
Due to all of these different influences, gold can defy the direction of the markets – and as investors know this and look to it as a store of value, this is a self-fulfilling prophecy that is unlikely to change in the years to come.
That makes gold and other negatively correlated commodities an excellent way to hedge your portfolio in uncertain economic times.
Even a relatively small percentage of your portfolio invested in gold can therefore be a sensible risk mitigation strategy, while benefiting from any gains in value that the yellow metal makes over time.
Disclaimer: The information provided here is not investment, tax or financial advice. You should consult with a licensed professional for advice concerning your specific situation.