How to Invest in Commodities the Right Way

By Dan

Investing in commodities is a lot different from investing in stocks and other financial assets. With commodities, you're typically dealing with a physical good, and managing that physical good takes effort that stock investors don't have to worry about. There are several ways to invest in commodities:

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  • Owning the physical commodity itself.
  • Investing in futures contracts that give you the right to take future possession of the physical commodity.
  • Investing in exchange-traded funds that own the physical commodity.
  • Investing in companies that produce or manufacturer the commodity.

We'll look at each of these methods below.

Owning physical commodities

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The most obvious way to invest in commodities is by buying the physical good itself. By owning the commodity, you'll have direct exposure to increases and decreases in its value, and you can sell the commodity at will when you want to convert your holdings back to cash.

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However, most physical commodities involve major logistical challenges. With commodities like gold, it's relatively simple to find dealers to sell you coins or bars, albeit often at a slight markup. However, it's a lot harder to take possession of 1,000 barrels of oil or a metric ton of copper. Because of those challenges, owning physical goods works well only in limited situations with certain commodities.

Futures contracts

Futures contracts offer investors a way to get exposure to changing prices of commodities without having to take physical possession. With a futures contract, you agree to buy or sell a certain amount of a commodity in the future, with an established price that can fluctuate with market conditions. If the price of the commodity goes up, then the buyer of the futures contract will profit. If the price falls, then the seller benefits.

One issue with futures contracts is that they typically offer extensive leverage. One might only need to put down a few thousand dollars to control a futures contract that covers $100,000 or more of the commodity in question.

However, if you think of your investment as being for the full value of the contract rather than just the money you're required to put down upfront, then you'll be much better prepared for the potential risks involved. In addition, futures contracts usually require specific authorization from your broker, and you might even need to get a different broker if your current provider doesn't offer futures.

Commodity ETFs

Many investors are more comfortable with exchange-traded funds, and you can find commodity ETFs that offer exposure to many different commodities. Many of these funds own vast amounts of the physical commodity among their own assets, and each share of the ETF corresponds to a theoretical amount of the commodity. That said, you can't actually claim the physical commodity itself -- your shares only give you an indirect interest. Other ETFs own futures contracts rather than physical goods.

Commodity ETFs have had mixed performance. Some track their commodities quite well, but others have done a terrible job. In particular, because futures contracts don't necessarily move in the same way as the physical commodity, many futures-based commodity ETFs have seen their values erode steadily over time. Make sure you're comfortable with how your ETF works before you choose one based solely on the commodity it owns.

Owning stocks that are connected with commodities

Finally, arguably the best way to invest in commodities is through shares of companies that benefit when prices go up. Mining companies and oil and gas exploration and production companies have direct exposure to commodities prices, and affiliated businesses, like heavy-equipment manufacturers and oilfield-services companies, tend to do better when the underlying commodities are performing well.

Individual stocks have the risk of a company-specific problem arising independent of the behavior of the commodity price. However, many stocks offer dividends or other return of capital to shareholders, and that added incentive can make a big difference compared to simply owning a physical good that can't produce any income.

Investing in commodities can be lucrative, but it's important to do so the right way. Although some investors actually benefit more from direct investments in commodity goods, most stock investors feel more comfortable tying their prospects to those of companies in the business.

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