There has been a significant amount of research conducted suggesting that commodities can be a valuable addition to investor portfolios. The impressive returns generated by this asset class historically serve as further evidence of the tremendous potential of commodities. But commodities are complex assets, and the options investors have for accessing this class are often nuanced and difficult to grasp. Moreover, dozens of resource families and specific hard assets exist under the commodities umbrella, many of which feature risk/return profiles that are drastically different from other commodities [see also Why Commodities Belong In Your Portfolio].

Commodities are inherently risky assets, but understanding the price drivers and details of the vehicles that offer exposure to these resources can empower investors to use this asset class efficiently. This guide covers some of the basics of investing in commodities, from the different types of exposure and vehicles to the primary drivers of returns.

In order to understand the potential benefits and drawbacks of commodities, it is first important to understand what exactly commodities are. Defining this asset class can be challenging; most will point to examples of commodities when asked exactly what a commodity is. Commodities come from a variety of sources; for example, gold is mined from the ground while cattle give live birth. Similarly, the uses for commodities are wide-ranging; copper is used primarily in construction, while sugar is used as a sweetener, input for certain biofuels, and a number of different applications. So defining commodities by the source or end use is fruitless.

Classification of a commodity focuses on the concept of fungibility–meaning that commodities can be treated as equivalent or interchangable by end users and financial investors alike. Essentially, fungibility requires identical (or near identical) physical properties; fungible goods are similar regardless of where they were produced or where they are located. Gold is perhaps the best example: a bar of bullion vaulted in New York is the same as a bar stored in Singapore. Light sweet crude oil is light sweet crude oil, regardless of whether it resides on a tanker in the middle of the Atlantic or in a pipeline in Louisiana [see also 25 Ways To Invest In Crude Oil].

Most financial securities are not fungible. Stocks of similar companies certainly aren’t identical; Pepsi and Coca-Cola, for example, may be similar companies but their stocks are obviously not interchangeable. The same can be said for bonds; debt issued by Ford Motor Company is not the same as debt issued by the U.S. government.

Fungibility is a critical concept in commodity markets, as it standardizes the market and allows investors around the world to trade high volumes of goods on a daily basis. No analysis of the underlying products is needed, and it often isn’t possible. Fungibility as it relates to commodities simplifies the valuation of these assets considerably; pricing of commodities is derived from supply and demand for a given resource–nothing more. Of course, predicting and understanding the drivers of supply and demand is no easy feat, but the pricing equation for commodities is extremely simple at heart [see also Three Things Wall Street Journal Didn’t Tell You About Commodities].

As mentioned previously, the commodity umbrella is a wide one, covering dozens of individual natural resources, many of which have very little in common from a physical or economic perspective.

Commodities can be bifurcated into soft commodities and hard commodities. Soft commodities are generally grown on plants or trees, while hard commodities are mined or otherwise extracted from the ground. Soft commodities include many agricultural resources such as corn, wheat, sugar, livestock, and soybeans. Hard commodities include industrial and precious metals such as gold, copper, nickel, silver, platinum, and zinc. Also falling under the “hard” commodity classification are oil products, such as natural gas and light sweet crude oil.

A more granular approach to commodities involves slicing the market up into “commodity families", groups of natural resources that generally exhibit similar physical properties and and uses. The six major commodity families include:

• Precious Metals: Gold, silver, platinum, and palladium all fall under this category.
• Industrial Metals: This category includes metals that are generally less expensive than precious metals, and used more widely in applications such as construction and manufacturing.
• Agricultural Commodities: This category includes natural resources that are frequently used for human consumption, including corn, wheat, and soybeans.
• Livestock: This category includes live animals–generally live cattle and lean hogs.
• Energy: Commodities related to energy production are among the most widely followed and traded; this category includes crude oil, natural gas, and other blends.
• Softs: This category, sometimes grouped with other agricultural commodities, includes coffee, cotton, and sugar. The naming conventions and classifications get somewhat confusing at this point; cotton is technically classified as a “hard” commodity, as it won’t spoil and can be quickly and easily used in many industrial applications.

It’s important to note that even within a specific commodity family, the factors that impact performance can be quite different. Gold, for example, is driven by very different supply and demand considerations than palladium, through both are classified as precious metals.

At this point, it makes sense to tackle a question that more and more investors are asking themselves and their advisors: why invest in commodities? The question may be rather simple, but the answer is quite complex.

When constructing a portfolio, most investors focus on the breakdown of holdings between stocks and bonds. Stocks are generally seen to be riskier assets, while bonds offer more consistent performance but lack the potential for significant price appreciation that equities can experience.

The case for investing in stocks and bonds is relatively straightforward. Both types of securities deliver a stream of cash flows to investors; stocks generate free cash flow from their operations and make dividend payments, while bonds make interest payments and/or return principal upon maturity. Commodities are unique in that there is generally no cash flow associated with the underlying asset; a bar of gold will never generate cash or make a dividend payment, and a field of wheat won’t ever make a coupon payment [see also 50 Ways To Invest In Gold].

So why invest in commodities at all? Most investors are aware that energy commodities are capable of recording huge price increases over relatively short periods of time, meaning that those who time the market correctly can turn a nice profit. But for those not interested in speculating on short-term swings, the appeal of commodities lies in the ability of this asset class to both smooth overall portfolio volatility and hedge against certain undesirable economic environments.

The concept of correlation as it relates to asset allocation is both critical and relatively simple; assets that generally move in the same direction maintain a strong positive correlation, while assets that tend to move in opposite directions are said to maintain a negative correlation. If there is no correlation between two assets, meaning that the performance of one can’t be predicted by the performance of the other, assets are said to be non-correlated. U.S. and international stocks exhibit a strong positive correlation [see also The Ultimate Guide To Natural Gas Investing].

The addition of non-correlated assets to a portfolio has the effect of smoothing its overall volatility, since individual components are unlikely to move in the same direction at the same time. One primary appeal of commodities lies in the correlation–or lack thereof–to traditional asset classes such as stocks and bonds. Numerous academic studies have shown that commodities exhibit low correlation to equities and fixed income, meaning that when added to traditional stock-and-bond portfolios this asset class has the potential to lower overall risk (see Six Academic Studies That Changed Commodity Investing).

Of course, smoothing volatility at the expense of overall returns may be a far less desirable outcome. There is evidence suggesting that commodities have historically delivered equity-like returns while smoothing overall volatility–in other words the best of both worlds when it comes to asset allocation strategies.

Inflation is a major concern for all investors, especially those living off of a fixed income. Rising prices erode the purchasing power of existing wealth, and eat into the returns of all types of assets. Another appealing aspect of commodities lies in the ability of this asset class to act as a hedge against inflation–in other words, appreciating in value when inflation kicks in, thereby offsetting losses incurred elsewhere in a portfolio as a result of a price increase.

The ability of commodities to hedge against inflation is easy to grasp. Inflation is an increase in prices, and as such will generally include an increase in raw materials prices that are inputs in both goods and manufacturing processes. In other words, inflation likely won’t occur unless the prices of raw materials, including oil, metals, and agricultural commodities, are on the rise [see also The Guide To The Biggest Companies In Every Major Commodity Sector].

The connection between commodity prices and inflation isn’t just hypothetical; several studies have proven the link between commodity prices and both expected and unexpected inflation (the latter version is of greater concern to most investors).

Commodities can also function as a play on continued global economic growth, and in particular expansion of emerging economies. As developing economies continue to urbanize at an impressive rate (rural populations gravitating towards cities), demand for raw materials to build out infrastructure, feed growing populations, and manufacture consumer goods such as automobiles is expected to increase. For those who believe that these favorable demographic trends will lead to an increased demand for natural resources, investment in commodities could be an optimal way to make a play on that investment thesis.

For investors looking to establish exposure to commodities, there are a number of different strategies, each of which has potential advantages and drawbacks. There are three primary options for investing in commodities:

1. Physical Exposure: The most basic manner of achieving exposure to natural resources involves simply buying and storing the desired commodity or commodities; this method ensures that investors have exposure to changes in the spot price of the resource. Unfortunately, physical exposure only makes sense for commodities exhibiting certain physical properties and maintaining a sufficient value-to-weight ratio to keep storage costs at a reasonable level. Storing gold coins in a safe is one thing, but attempting to gain physical exposure to crude oil or livestock presents a host of logistical and cost hurdles.
2. Futures Contracts: Developed commodity futures markets allow investors to gain exposure to commodity prices through financial contracts that hold natural resources as the underlying assets. While this method simplifies the investing process, it also introduces additional risk factors; returns to futures-based commodity investing are dependent not only on changes in spot prices, but also on the slope of the futures curve and the prevailing level of interest rates.
3. Commodity-Intensive Stocks: The final of the three primary options for commodity exposure involves investing in stocks of companies that are engaged in the production or extraction of commodities. Because the profitability of these firms generally depends on the market price for their goods, their outlook will tend to improve when relevant commodity prices increase and vice versa.

Commodities are a wide-ranging subject matter, and this guide has only scratched the surface of everything there is to know about investing in this asset class. For more on how to optimize your experience investing in commodities, visit the CommodityHQ Library or check out any of these additional resources:

• Hard Assets Investors
• Facts and Fantasies About Commodity Futures
• Commodities News

Disclosure: No positions at time of writing.