How does investing in commodities work?

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How does investing in commodities work?

Investing in commodities is an activity undertaken by many investors, who may decide to specialise in the sector or to include these assets as part of a portfolio diversification strategy: for example, to provide a degree of decorrelation from equities or bonds in some cases, and a form of inflation protection in others. This is a very broad category of assets, ranging from wheat to oil, from metals to diamonds, from cocoa to timber.

Hard and soft commodities

A first, very general distinction can be made between 'hard commodities' and 'soft commodities': the former include metals, minerals, fossil fuels, etc.; the latter mainly agricultural products, but also livestock. As far as market trends are concerned, experts point out that hard commodities are more linked to the economic cycle (they are more linked to industrial production and transport); soft commodities, on the other hand, are more dependent on weather conditions (which, of course, affect planting and harvesting).

How to invest in the commodities market?

But how does investing in commodities work? This is a legitimate question, as it is a market in which it is complicated - and in some cases impossible - to invest directly in a commodity, i.e. to buy it physically.

Exchange Traded Commodities (ETC)

Exchange Traded Commodities (ETCs) are passive financial instruments that track the price of a commodity. A particular advantage is that they make it possible to invest in a commodity without having to physically buy and hold it. However, a distinction must be made between commodities that can be stored (e.g. silver and gold) and those that are more difficult to store (e.g. gas and oil). In the case of easily storable commodities, ETCs reflect spot prices, i.e. the exact price of the commodity; in the case of commodities that are difficult to store, prices are necessarily based on futures contracts that expire every month: this results in continuous buying over time, often leading to a misalignment of prices, known in financial jargon as the 'contango effect'.

The role of futures

Among the most popular products for investing in the commodities market are futures: these derivative financial products are in fact standardised contracts for the purchase and sale of a specific commodity, with both the date and the selling price fixed in advance. Futures usually have two functions: 1) hedging against volatility risks, and 2) speculating on price movements. However, these instruments - which can be extremely risky, especially when combined with leverage - are usually used by professional investors and brokers. These derivative contracts are also traded on specific markets, the first of which was the Chicago Board of Trade; today the main ones are the CME Group and the Intercontinental Exchange (both based in the United States), the London Metal Exchange and Euronext; more recently, following the gas price crisis due to the conflict between Russia and Ukraine, the Title Transfer Facility (TTF), a specific futures market based in Amsterdam, has been frequently heard of in Europe.

The actions of companies in the sector

Investing in commodities can also mean exposing your portfolio to equity investments in companies involved in the commodities sector. For example, if you believe that a commodity, such as copper, is destined for growth, you could invest in companies involved in the extraction and processing of copper. However, the performance of these companies may diverge from that of the commodity in question: it is well known that the performance of a company's shares is also determined by factors specific to the issuing company.

Alternative investments

In some cases, given the nature of the commodity, investing in commodities simply means buying a certain quantity without having to resort to regulated markets. One of the most typical examples is the purchase of bars, jewellery or gold coins. The risk in this case varies depending on which asset you choose to hold physically. However, investors who buy commodities directly must always take into account a) the cost of storing and insuring the assets and b) the liquidity risk, which is on average higher than for listed instruments.

Read also

What are financial derivatives? Futures, Forwards, Options and Swaps

Alternative investments: risks and advantages

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