A Primer for Investing in Commodities

Investing in commodities is a popular way to diversify your portfolio because they can hedge against inflation. However, some experts warn that commodities can be volatile and therefore require scrutiny. Here is a brief guide to investing in commodities.

What are commodities? Commodities are raw materials that are traded on exchanges. They are classified into three types -- energy, metals and agricultural products -- though they may also include products like stock indexes and foreign currencies.

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According to CME Group, which owns the Chicago Board of Trade, crude oil is the most actively traded commodity in the world. Other core commodities include corn, soybeans, natural gas, gold and silver.

Investing in commodities Keep in mind that commodities as an asset class can be volatile and therefore deserve "considerable research and scrutiny," says Alan McKnight, the director of global investment strategy at Atlanta-based investment advisory firm Balentine. "Investors should be very careful. ... It is important that they have a clear understanding of the spot and futures markets," he says.

Futures and spot markets  According to CME Group's "A Trader's Guide to Futures," futures are standardized contracts for the purchase and sale of commodities.

The futures markets are mostly made up of hedgers and speculators. Hedgers buy and sell on the futures markets as a way to manage price risk. They may be commercial or institutional users of the commodity, like farmers and exporters. Ideally, hedgers want to establish an acceptable price margin between the cost of the raw materials and that of the final product.

Speculators may be individual traders or portfolio managers who provide a large part of the market's liquidity and are looking to profit from price fluctuations.

Meanwhile, the spot market is where cash transactions for the physical or actual commodity occur. Commodities or securities at spot markets are sold for cash and delivered immediately or within a timely manner.

ETFs Investors who don't want to get involved directly with futures can invest in commodities via exchange-traded funds (ETFs), which invest in different securities but trade like stocks.

Will Rhind, managing director of New York-based ETF Securities USA LLC, says ETFs are a cost effective, easy, liquid and transparent way of accessing global commodity markets. Commodity ETFs track the spot price or relevant commodity index and are bought and sold via brokerage accounts like shares.

Rhind says purchasing physical commodities like silver or gold coins can be expensive and impractical as they involve physical storage and insurance, but ETFs remove these worries as physical storage is provided by the fund.