Investors may look to commodities to diversify their portfolios outside of traditional investments.

🤔 Understanding how to invest in commodities

There are five basic ways to invest in commodities.

Futures contracts

Futures contracts are designed for use  by commercial and institutional investors with a need for the raw commodity. These legal agreements set terms for traders and sellers to exchange the goods for a predetermined price at a set point in time.

Speculative investors (advanced traders looking to profit from price changes) may also trade futures contracts. However, as they have no need for the goods, they usually close the contract before delivery. Another way investors may trade is with futures options, which gives the right but not the obligation to exercise their contract.

Commodity pools

Another way to get started investing in commodities is to put funds into a commodity pool. In these arrangements, a CPO – commodity pool operator – gathers money from investors to buy a futures contract or option. CPOs must abide by certain regulations, such as:

• Keeping detailed records
• Providing annual financial reports
• Giving investors access to quarterly account statements

Typically, a CPO employs a CTA (commodity trading advisor) to offer investing advice. These situations come with the advantage of having a licensed professional on hand to help manage investments. Plus, smaller investors with less capital can purchase a stake in larger contracts to seek larger gains.

ETFs, notes and commodities

ETFs (exchange-traded funds) and ETNs (exchange-traded notes) are another commodity investing opportunity. Like stocks, these investments allow investors to profit from price fluctuations – without the need to sign a futures contract themselves.

When it comes to commodity ETFs, these funds track the price of a particular commodity or sector using futures contracts as their baseline. Others may back their fund by holding the commodity in storage.

On the other hand, ETNs are unsecured debt securities that mimic the fluctuation of a commodity or index. These investments are backed by the issuer. While they let investors participate in the commodities market without a special brokerage account, they do come with a higher credit risk.

Furthermore, while these investments trade like stocks, not every commodity has an ETF or ETN. And just because an underlying commodity moves, that doesn’t mean the fund will benefit from price changes.

Stocks and commodities

More commonly, investors get involved with commodities markets by purchasing the stock of companies that engage in commodities production. For instance, energy investors may put their money into mining corporations or solar farms. Or people who are interested in agriculture may invest in farms or slaughterhouses.

One of the biggest advantages of stocks over futures is that there is more information available. Plus, they’re more liquid, as you’re more likely to find an investor who wants to buy out your stock position (as well as a broker to facilitate your trades).

On the other hand, investing in commodities stocks is not the same as playing on the commodities market. Just because the price of gold goes up doesn’t mean your preferred mining company will realize gains. Furthermore, there are plenty of company-related factors that may influence the price of a stock outside the global factors that influence the price of the physical commodity.

Mutual funds and commodities

Unlike commodities futures and stocks, mutual funds don’t directly invest in commodities. However, there are a handful of mutual funds that invest in:

• Stocks from commodity-related industries
• Commodities futures contracts
• Commodity-linked derivatives and securities

Of course, this doesn’t mean that mutual funds are “safe” or risk-free; like all investments, there is a chance of losing your principal. Additionally, they tend to come with higher management fees and sales charges than ETFs, which can eat into potential profits.

What this means for you

Commodities can help you diversify your portfolio. And you're spoiled for choice of investment vehicles. Diversifying is key to a successful portfolio performance.