Investing in commodities: the risks and returns of investing in gold, coffee, oil and more

The prices of many commodities has soared in recent years but remain highly volatile. Should you invest in them?

Commodities are everywhere

There’s a good chance that you’re already helping fuel the booming global demand for commodities.

Every cup of coffee drunk, bowl of cereal consumed, and gallon of petrol put in your car is boosting this sector.

So should you be committing even more of your cash to commodities – over and above how much you spend on the weekly shop?

This article is part of a wider series on investing, covering all areas from stocks and shares to buy-to-let, peer-to-peer and alternative investments. Click here to view the full guide.

What are commodities?

Commodities are best described as raw materials and are typically divided into three categories: agriculture, energy and metals.

Agriculture includes sugar, cocoa, coffee, wheat, oats, corn and soybeans, alongside cotton and lumber, as well as animals such as cattle and lean hogs (pigs).

Energy means crude oil, gasoline and natural gas, while metals can be precious or industrial, and include gold, silver, platinum and copper.

While these areas differ enormously from each other, their valuations are all affected by the straightforward economics of supply and demand.

Prices will rise when demand is high and supply is limited. When demand falls the opposite occurs. The key to success is being on the right side of such movements.

Why would you invest in them?

The attraction is buying into the long-term story in the hope of making bumper returns over the years, according to Patrick Connolly, a chartered financial planner with Chase de Vere.

“The theory is their demand will rise as global populations increase and we see the continued development and infrastructure spend in emerging markets,” he explains.

Exposure to commodities can also help spread your risk.

“There’s a strong argument that commodities can provide diversification benefits as they typically have a low correlation to assets such as shares and bonds,” he adds.

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Demand for commodities

Demand for commodities has soared over the past 20 years, fueled by rapid growth in China, according to the Commodity Markets Outlook from the World Bank Group.

“The outlook for commodity prices is vulnerable to policy-related risks, especially in the short term,” it stated.

The report highlighted how growing trade tensions since the start of 2018, notably the imposition of tariffs by the United States, have had a material impact.

“However, it is likely that the effect of any additional tariffs or sanctions would moderate over the medium-term, as producers and consumers find new distribution channels and export markets,” it concluded.

What influences commodity prices?

An almost endless stream of factors can affect valuations.

As well as general demand, there is the success of individual crops, potential political instability within certain countries, and broader, global economic factors.

Bad weather can have a significant impact on demand for agricultural commodities, with prices tending to soar if harvests yield less than expected.

Precious metals such as platinum and gold, meanwhile, are more expensive than industrial metals because they’re in much shorter supply, according to Chase de Vere’s Connolly.

“Their price, and those of other commodities, rises when demand for them grows, and falls when demand slows,” he explains.

Political and global macroeconomic factors are a key influence on commodity prices too.

While commodities generally benefit when global growth is strong, as there is more production and greater infrastructure spend, they can suffer due to political concerns.

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Pros and cons of commodities

The idea is you benefit from having exposure to booming demand for various commodities – but it’s an area that’s not for the faint-hearted.

There can be huge levels of volatility and so investors can very quickly make significant gains or losses – and this can be unsettling for investors.

This presents a conundrum for many people. While they might be attracted by the diversification benefits and upside potential, can they afford potentially heavy losses?

“There are potentially massive gains to be made but investors need to accept it’s going to be a very volatile ride along the way,” adds Mr Connolly.

Gold is a special case

Gold has been popular for centuries – and is still beloved by many investors looking for something that won’t react in the same way as traditional assets.

Gold doesn’t produce any income, interest or dividends. It just sits there. This means its price depends solely on demand and supply - and how much people are prepared to pay.

However, the gold price has been volatile. Having reached more than $1,800-an-ounce in 2011, it fell to less than $1,100 at the beginning of 2016, and is currently around $1,300 (late Jan 2019).

While often regarded as a safeguard against global struggles, the fact is it will suffer when the US dollar is strong and less demand from India.

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Exposure to commodities

There are three main ways to access the sector: through individual companies; an investment fund; or an Exchange Traded Fund.

Investing in individual stocks means buying shares in the likes of mining stocks such as Rio Tinto, or oil majors Royal Dutch Shell and BP.

However, the value of your investment will be totally dependent on the fortunes of the stocks you have bought – as well as the sector backdrop. This makes it volatile.

One potential solution is opting for an investment fund that has a number of commodity exposures, thus diluting the risk being taken.

One answer could be an investment fund, which may directly hold the underlying commodities but is far more likely to invest in the shares of companies that are actually involved in one or more of the commodity sub-sectors, such as mining.

Those who take a long-term view and are not too phased by volatility, could find a straightforward unit trust is perfectly adequate for their needs.

Another option is Exchange Traded Funds, which are generally low cost, flexible and attractive ways to get exposure to different markets.

Although these can be linked to a specific commodity index, products are increasingly becoming available linked to the actual physical commodities themselves.

Boom and bust

Commodities have had mixed fortunes in recent years, according to Darius McDermott, managing director of Chelsea Financial Services.

While a few funds have closed, the main ones remain open and there has been an increase in the number of ETFs launched, due to popularity for these types of products.

“Commodities enjoyed a super-cycle from the turn of the century to 2010 - then they came crashing down - losing some 75% of their value between 2011 and 2016,” he says.

Since then they have done a little better but it’s been mixed.

“Gold has struggled even though there has been a lot of uncertainty in the world and the price of oil has come off a lot,” he adds.

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Don't become too exposed

Arguably the biggest potential problem is being over-exposed to commodities, according to Patrick Connolly at Chase de Vere.

“Most investors will already have exposure to commodities through more broad-based investments they hold,” he says.

For example, the UK stock market has a high weighting to commodities with about 27% of the FTSE-100 made up of commodity-related stocks.

Risks can be reduced by investing in commodity and natural resources funds which spread investments over different types of commodities, but these funds can still be hugely volatile.

As most investors will already have exposure to commodities through more broad-based investments, Connolly’s Chase de Vere is wary of adding too much more.

“If investors are particularly keen to add further commodity holdings to their portfolio, we would suggest a maximum weighting of 10%,” he adds.