An introduction to commodities

If you’ve watched Trading Places, you’ll recall the Dukes’ somewhat rudimentary depiction of the world of commodities and their role as brokers, as well as the sometimes frantic activity in the trading pits. In the 40 years since the movie’s release, most “open outcry” trading pits have been replaced by more efficient electronic trading systems, and additional safeguards and regulations have been introduced. Here, we explore the commodity asset class and its role in investor portfolios.

Using the Bloomberg Commodity Index (“BCOM”) as a proxy, commodities can be grouped broadly into energy, metals and agriculture commodities, but also can be split into the following sub-sectors. 

The evolution of the futures exchange

Some commodities are still bought and sold in a traditional, physical transaction, but most trading now takes place on the futures exchanges and over-the-counter market. The Chicago Board of Trade (CBOT) was created in 1848 as a cash market for grain farmers looking for potential buyers. In 1865, the CBOT introduced the standardised futures contracts that we know today, making transactions more efficient and opening the door to other participants.

There are now futures exchanges in financial hubs across the world, but the most relevant for most investors are the CBOT, Chicago Mercantile Exchange (CME), New York Mercantile Exchange (NYMEX), Commodity Exchange (COMEX), Intercontinental Exchange (ICE) and London Metal Exchange (LME). A commodity’s futures tend to trade on just one exchange.

The standardisation aspect is vitally important. A futures contract has precise specifications, including the quantity and quality of the commodity to be delivered, as well as the expiration and delivery dates. Each commodity future will have specified contract months that can be traded. 

The most actively traded contracts tend to be those for the nearest delivery month (the “front month”). Futures trades are cleared centrally, and margins are paid by the clearing members. Today, futures are traded not only by those interested in the physical commodity but also by investors who want exposure to the commodity’s price but do not want to ever take physical delivery.

Gaining exposure to commodities

While you could buy and hold some commodities physically, it is costly and extremely inefficient when you factor in transportation, storage and insurance costs. You would also have to locate someone willing to sell you the commodity and negotiate a price and delivery terms with them.

If you don’t want to hold the physical commodities (most people don’t) but instead simply want exposure to their prices, futures may be a better alternative. You’ll need to remember to close out your long futures position or roll it into another month’s contract before it expires, unless you want someone showing up at your front door to deliver a lorry-full of the commodity. Futures can be cost-effective because you only need to put up a fraction of the contract value, called margin. You may be required to top it up whenever the futures price goes down – known as a margin call.

However, the most popular way most investors gain exposure to commodities is through exchange-traded products. You can gain exposure to a single commodity’s price via an exchange-traded commodity (ETC) or to a basket of commodities, such as those represented by the BCOM Index, via an ETF. Investing in these types of products provide simple, cost-efficient exposure without having to worry about receiving margin calls, rolling the futures or having a lorry turn up at your front door.    

Why invest in commodities

Commodities can provide investors with three potential benefits:

Diversification. As an asset class, commodities show low correlation with equities and bonds, which is particularly useful for achieving portfolio diversification. Individual commodities may be driven by a wide range of factors including politics, regulations, weather, seasonality, the economy, replacement, supply and demand, which are different from those impacting equity and bond prices. How much should be allocated to commodities depends on the composition of the existing portfolio, but studies suggest 5-10% may make a meaningful improvement to the typical risk-return profile.

Inflation hedge. Commodities tend to be positively correlated to inflation, with rising commodity prices often a contributing factor in higher inflation readings. We have witnessed this in recent years with rising energy and food prices stoking multi-decade highs in inflation around the globe. 

Growth opportunities

Commodities also provide potential growth opportunities linked, for example, to emerging market growth or the transition to a low-carbon global economy. Demand for industrial metals would be expected to grow as an expansive economy spends on building out infrastructure, housing, etc, while many of these materials are also used in solar, wind and other renewable energy technologies. In agriculture, some grains – especially corn – are used not only to feed the world but also to feed into the production of biofuel. These are just some of the potential growth opportunities you can access via an investment in commodities.