Commodities: How to Invest in Commodities and Why

I was reading Larry Swedroe’s The Only Guide to Alternative Investments You’ll Ever Need the other day, I have been thinking about adding commodities to my portfolio.  No, I am not going to go out and buy a futures contract; however, I have been thinking about adding commodities to my investment portfolio as part of my asset allocation strategy. Commodities have been taking significant hit this year as evident by QRAAX (represents the S&P GSCI index) and by PCRIX (represents the DJ-AIGCI index).

What are Commodities

Commodities comprise a broad category of raw materials used by industries and traded on specialist commodities markets that include energy (e.g., natural gas and oil-related commodities), industrial metals (e.g., copper, aluminum, lead, nickel, and zinc), precious metal (e.g., gold and silver), agriculture (e.g., wheat, corn, soybeans, cotton, sugar, coffee, and cocoa), and livestock (e.g., cattle and hogs).

The two indices representing commodities are represented by QRAAX and PCRIX:

QRAAX

qraax

PCRIX

pcrix

Why You Should Invest in Commodities

Commodities are a source of inflation and thus provide a strong hedge against it. Commodities also convey substantial diversification benefits due to its negative correlations to both stocks and bonds.  In short, adding a small amount of commodities, say 5%, can improve your overall portfolio in several ways; specifically, better overall performance due to diversification and lower risks.

How to Invest in Commodities

There are several ways to gain exposure to commodities without the complexities of futures trading.  As mentioned earlier there are mutual funds, such as QRAAX and PCRIX that tracks the S&P GSCI and DJ-AIGCI, respectively.  Unfortunately, QRAAX has a fairly steep expense ratio of 1.37% and PCRIX has a prohibitive minimum initial investment figure.  Other options include commodity-related Exchange-Traded Funds (ETFs) and Exchange-Traded Notes (ETNs).  Here are a few that’s worth looking into:

  • GSG – iShares S&P GSCI Commodity-Indexed (ETF)
  • DJP – Dow Jones-AIG Commodity Index Total Return (ETN)

Here’s a comprehensive list of commodity ETFs and ETNs.

Obviously, investing in commodities is not without risk and it’s not atypical for commodities to underperform for an extended period of time. Additionally, as you diversify your portfolio, it will become harder to track your performance against standards like the S&P 500, which may add a new level of anxiety.

Do you currently invest in commodities?  Could you share your thought with us?

Reviewed and updated May 13, 2011.

About the Author

By , on Dec 24, 2008
Pinyo
Pinyo is the owner of Moolanomy Personal Finance. He is a licensed Realtor specializing in residential homes in the Northern Virginia area. Over the past 20 years, Pinyo have enjoyed a diverse career as an investor, entrepreneur, business executive, educator, and financial literacy author.

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Leave Your Comment (16 Comments)

  1. Jonathan says:

    Thanks so much for such a clear over view of commodities trading. I’ve actually being doing a little research into this myself, but your analysis was much more comprehensive and helpful. Thank you so much.

  2. Commodities are so risky right now, I don’t if I’d be willing to take the chance. Yes, I see that the price of nearly everything is growing, so there might be a potential for a nice return, but the way the markets are going right now, I’m not sure I would run the risk. My preference is real estate…especially in this market.

  3. Paul says:

    You must realize that commodities are a natural hedge against inflation and unfortunately for commodity traders we have been in a deflationary market environment the past few months. However, I think it’s a necessary addition to your asset allocation due to it’s low correlation with equities and I suspect we will see a period of increased inflation over the next few years. Once credit conditions improve we’re likely to see the kind of inflation we saw in the late 70′s under Volker.

    From a technical analysis perspective commodities are probably not at their bottom just yet but for the long term investor it’s probably a great time to buy low which is always the best time to buy. Just remember to take your profits by rebalancing your portfolio on quarterly basis because you never know how this Fed is going to act.

  4. Pinyo says:

    @Start-up — No, I haven’t yet — I am still trying to clean up some credit card debt and max out my 2008 Roth. Once I have money to invest, I’ll probably start off with GSG or DJP, unless I can find something less expensive.

  5. Matt SF says:

    If I could throw out a decent idea… there are hydrocarbon based trusts/MLPs that are paying high yield dividends in the 8-20% range. Not to mention, if oil goes back up (which it probably will), you also get the equity appreciation.

    The risk is fairly high compared to a full fledged index fund, but if you buy on the huge pullbacks in oil, and set your stop loss orders, you should be OK.

    PBT and NGT are good examples if anyone is curious.

  6. Start-Up says:

    Pinyo,

    Have you jumped into the commodities sector yet? If so, where did you choose to invest? If not, I hope you blog about the experience and end result.

  7. Kenny G says:

    Commodities investing requires a lot of skills. So, if you don’t want to through your money away, you must study carefully first. Thanks for your post! It really makes sense for all beginners .

  8. Kevin says:

    I was actually thinking of getting into some oil stocks (dividends + play on oil) or possibly an oil ETF. I can’t believe oil will remain where it is over the long run as it is a finite resource.

  9. Pinyo says:

    @Craig – Commodities is extremely volatile even compared to this year stock market. Just take a look at the two charts above. Do you see that in both cases commodities price went up higher than the S&P500 and dropped well below the S&P 500? That’s volatility.

  10. Pinyo says:

    @Craig – I think this is a terrific time to buy oil. In any case, investing in commodities is not like investing in U.S. large cap stocks; and in my opinion should not replace it. Personally, I am planning to add about 5% position in commodities either via an index fund or ETF (but I still have to do some more reasearch). Also, I am not planning to buy specific commodities, but looking for something that track the overall commodities market.

  11. Craig says:

    @pinyo That’s a good point. I guess nothing is real safe, especially these days.

  12. Craig says:

    @pinyo that never hit me to buy in oil right now. You have to imagine within 5 years the prices will be over $3.00 again. Tracking overall commodities market would make sense in a more long term strategy. For me, I am brand new to this and investing in general, trying to learn the basics. Seems like even buying individual commodities is less of a risk than individual stocks right now.

  13. Craig says:

    Up until a few months ago investing in oil would have been a gold mine. I hear alot about commodities and they seem more of a blue chip to invest in over the long run. Do you think this is true? Maybe I should think about putting money into a commodities mutual fund.

  14. Jeff Rose says:

    FYI. I’ve used Managed Futures for a portion of some of my clients portfolios. As of the end of November, that portion of our portfolio is up just over 19%. It’s nice because we actually have something positive to talk about during this horrible year.

    If you have to be ready to handle volatility if you are going to invest in these type of investments. Although, they can reduce the overall risk of the portfolio, that doesn’t mean they reduce volatility.

  15. Matt SF says:

    I trade commodities, or commodity related stocks, on a regular basis. This year saw amazing volatility in previously ultra boring areas of the economy (e.g. coal, corn, etc), so buying the ETFs with a good stop loss order to protect yourself from a freak sell off is the way to go — for me at least. The main danger lies with the weekly inventory reports where a shortage can result in a big up move, or a glut can cause down move in a matter of seconds. Especially in oil or nat gas.

    I’ve been following the natural gas market (via the UNG) for a few days now waiting for a chance to get in. Dennis Gartman (bigtime commodities expert) said if he had to buy one commodity last week, it would be grain. The GRU would probably be the best method to buy grain for average investors.

  16. Trevor says:

    No I haven’t heard or know anyone that has invested in commodities.

    Thanks for teaching me something new and giving me something to discover and learn.

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