Many investment advisors believe that it is good practice to maintain a diverse portfolio. A portfolio spread across a range of asset classes is believed to reduce the risk inherent within the portfolio. Provided the asset classes are unrelated it is unlikely that there will be simultaneous falls in value across the asset values and as an investment as a whole.
Investment diversification reduces risk provided the asset classes within the portfolio do not correlate. Commodities can made a useful contribution to a portfolio because commodity prices generally negatively correlate with share and bond prices and correlate positively with inflation. In theory, commodity prices rise when share and bond prices are on the wane and rise. They also rise when there is inflation in an economy.
Although commodities can be used as a diversification investors need to express care. At the time of writing the commodities market is very buoyant and it is an open question whether strong market conditions can continue. These are very volatile markets that can fleece the amateur investor.
These are many ways in which an investor can gain exposure to the commodities sector. An investor can (i) invest in the commodity itself, (ii) invest in a mutual fund that has exposure to the sector, (iii) participate in the market through a range of future and derivative products and (iv) invest stocks and shares that support companies that have a direct exposure to the share price.
As there are many different commodities investors need to determine not just how much of their portfolio should be invested in commodities but also much should be invested in each commodity. The traditional commodities used with a diversified portfolio are oil, gold, precious metals and industrial metals. These are considered to be hard commodities because they can be stores. Agricultural commodities such as wheat, cattle, orange juice and vegetable oils are considered soft commodities because they can be grown rather than extracted from the ground. There is more scope to expand the supply of soft commodities. The market is highly fragmented. Each commodity has a unique set of supply, demand, speculation and consumption parameters that determines the price. Some commodity markets are very specialist and not very liquid. When investing in commodities it is important to conduct, or commission, research, to understand the market.
Although widely used by professional brokers commodity futures and derivate markets are a high risk class which is best avoided by amateur investors. A commodity futures market is one in which the investor pays a premium for the right to purchase the commodity at a future price at a specified date in the future. The investor makes a gain if the price rises above the specified future price and suffers a loss if the price falls. The market is extremely high risk because brokers usually take highly geared positions.
Investors who chose to invest in the commodities market using a mutual fund are spared the need for detailed research and understanding of the market. Mutual fund investment is also more suited for the small investor. Mutual fund investment should allow the investor to make modest periodic investments in the market. By making regular monthly payments into the mutual fund the investor can make periodic investments into the commodity market. Regular monthly payments should protect the investor from volatile price movements. Many mutual funds provide switching facilities which enable the investor to balance their funds. Check whether the find manager has facilities to switch into other commodities from time to time.
Rather than investing directly in the commodities market investors may chose to take a shareholding in companies that are exposed to the sector. This approach is not as effective at risk diversification but may, with research, offer attractive returns. Investors can chose between established companies or start ups. Start ups such as oil exploration companies, mining exploration companies and new agricultural ventures can offer great returns. However their share price is dependent upon so many factors, such as feasibility studies, availability of finance and market sentiment, that they are not a mere play on the commodity price.
Portfolio diversification using commodities as an asset class is possible. However, commodities are a complex asset class which is not best suited to an amateur investor. A small investor is best advised to gain exposure to commodities by investing in a specialist mutual fund.