Forms of Commodity Investments | CFA Level I Alternative Investments

In this lesson, we’ll explore commodities as an alternative investment. We’ll learn about various forms of commodity investments and discuss some potential benefits of investing in commodities.

Commodity Categories

Commodities are physical products and can be categorized as:

• Energy
• Base metals
• Precious metals
• Agriculture
• Other types, created to meet manufacturing needs as technology evolves

Unlike most other investments, commodities don’t provide an income stream to investors. Instead, investors seek to profit through changes in the price of the underlying commodity.

Commodity Derivatives

While it’s possible to invest in commodities physically, most investors gain exposure to commodity prices through derivatives. Common forms of commodity derivatives include futures, forwards, options, and swaps.

• Futures and forwards are obligations to buy or sell a specific amount of a given commodity at a fixed price on a specified date. Futures are exchange-traded and typically cash-settled, while forwards are traded over-the-counter and involve physical delivery.
• Options give holders the right, but not the obligation, to buy or sell a specific amount of a given commodity at a fixed price on or before a specified date in the future. Commodity options can be exchange-traded or OTC traded.
• Swaps are agreements to exchange streams of cash flows based on future commodity or commodity index prices. Swaps are traded only on the OTC market.

For more details on derivatives, refer to the derivatives course.

Other Commodity Investment Forms

Besides commodity derivatives, other means of achieving commodity exposure include:

• Exchange-traded funds (ETFs) that track the performance of specified commodities, like the SPDR Gold Trust ETF, which aims to track the price of gold.
• Equities directly linked to a commodity, such as shares of a commodity producer like an oil producer or gold mining firm. Note that the stock price and commodity price may not be perfectly correlated.
• Managed futures funds can be focused on specific sectors or diversified across multiple sectors. They can be structured as limited partnerships or mutual funds, with varying fees, liquidity, and investor restrictions.
• Individual managed accounts tailored to the portfolio needs of high net worth individuals or institutional investors, managed by professionals with expertise in commodities.
• Specialized funds that focus on specific commodity sectors, such as oil and gas, grains, precious metals, or industrial metals.

Why Invest in Commodities?

Though commodities have historically had lower returns and higher standard deviations than global stocks or bonds, there are reasons to invest in them:

• Capital gains potential: Speculators can earn high returns over short periods when their expectations about short-term commodity price movements are correct.
• Diversification benefits: Commodity returns have low correlations with global equities and bonds, providing diversification to a traditional portfolio.
• Inflation hedge: Holding commodities can act as a hedge against inflation risk, as some commodity prices, like energy and food, are factored into the consumer price index calculation. This results in a positive correlation between commodity price changes and inflation indices.

And that wraps up this lesson on types of commodity investments and their benefits. In our next lesson, we’ll delve into commodity pricing and valuation.