This post is an excerpt from Wells Fargo Investment Institute’s “Ask the Institute” series.

What are commodities? The basic building blocks for essentially everything, commodities are the raw materials grown on farms or pumped or mined out of the ground. In the investment world, commodities are a major asset class, similar to stocks or bonds.

Investors typically choose commodities because they can add diversification benefits. Commodities often run counter to other major assets, especially stock markets—shown in the chart below. The top portion represents commodities and the bottom stocks. The shaded areas represent the bear markets for each. Note that the different shadings give the chart a “checkered” look. When commodities have been in a bear market, stocks have frequently been in a bull market, and vice versa. Investment portfolios can benefit from such differences.

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Why do commodities move opposite stock markets? Commodities are major input costs for companies, many of which trade on stock markets. When commodity prices rise, it can cost a company more to produce its products. This can weigh on the company’s stock price. On the flip side, if commodity prices fall, that same company can probably produce its products more cheaply. This can be looked at favorably by stock investors.

Increasing Returns—and Risk

There is no free lunch, of course. Adding commodities to portfolios does typically come with more risk. Investors, though, have historically been paid for the added risk through extra returns—as indicated by the chart below. The chart highlights two different portfolios in a historical perspective called the “efficient frontier.” The blue line represents a portfolio comprising stocks, bonds, and cash alternatives. The green line represents a portfolio including stocks, bonds, cash alternatives, plus commodities. Each dot represents the expected portfolio returns for a defined level of risk, based on historical performance. If a free lunch did exist (which it does not), it would sit in the upper left corner—lots of return with little risk. Note that the line for the portfolio including commodities sits a little higher than the one for the portfolio without commodities. This shift indicates that mixing commodities into portfolios has historically increased returns, but with added risk.

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There are a variety of strategies for gaining exposure to commodities: Commodities futures contracts are legal obligations to buy or sell a commodity at a date “in the future.” The buyer agrees to purchase the commodity at a predetermined future date and price, and the seller agrees to deliver. It’s important to understand that the underlying commodity specified in the contract is seldom physically delivered to the buyer. For example, it’s unlikely that a speculator in wheat actually wants to own any wheat. Instead, he or she wants to take advantage of the potential for wheat prices to increase. And the way that’s traditionally been done is through buying wheat futures.

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This type of trading and investing is not for everyone. Futures are a form of derivatives trading. In other words, the value of the contract an investor purchases is based on (derived from) the price of the contract’s underlying commodity. The futures and commodities markets can be highly unpredictable. Prices often move dramatically. This can happen so quickly that you may not have time to cover or get out of your obligation, and you may lose your entire investment. In some cases, you may lose even more than you invested. There can be times when you can have trouble liquidating your futures contract, which may limit your access to cash. You should know that using leverage can magnify any price movements and lead to extreme volatility. Prices may plummet and rise, making it extremely difficult to determine when to get out.

Stocks

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Packaged and Professionally Managed Commodities Investments

blog-20160727-chart5Some investors may not want to buy individual futures or stocks to gain exposure to commodities markets. For those investors, there are other investment vehicles, such as exchange-traded funds (ETFs), mutual funds, or professional money management.

ETFs. An ETF is an investment company that typically tracks the yield and return of an index, such as the S&P 500. It holds a basket of securities and trades like a stock throughout the day on a national exchange. A commodity ETF attempts to track the price of a single commodity and hold it in physical inventory or it may purchase futures contracts or track a futures index.

A commodity ETF may also attempt to track the performance of a particular commodity index, similar to a stock ETF that’s designed to mimic the performance of the S&P 500. This type of commodity ETF may use a combination of physical commodity ownership and investing in futures. Unlike a traditional ETF, most commodity ETFs are not registered as investment companies so they are not subject to the same regulatory requirements as mutual funds or ETFs that are registered.

Mutual Funds. For diversification, there are mutual funds available that invest in commodity-related company stocks. These funds may also use futures contracts to track an underlying commodity or commodity index.

Professional Money Management. Rather than trading futures directly, many investors turn to managed futures funds, which employ professional money managers, known as Commodity Trading Advisors, that specialize in futures trading. Managed futures are an alternative investment strategy which aims to profit from trading in financial futures, commodity futures and foreign exchange markets. These types of investments are not suitable for all investors.

 

All investing involves some degree of risk, whether it is associated with market volatility, purchasing power or a specific security. There is no assurance any investment strategy will be successful or that a fund will meet its investment objectives. An investment in a mutual fund or exchange -traded fund (ETF) will fluctuate and shares, when sold, may be worth more or less than their original cost. ETFs are subject to risks similar to those of stocks and may yield investment results that, before expenses, generally correspond to the price and yield of a particular index. There is no assurance that the price and yield performance of the index can be fully matched.

Trading in futures contracts on physical commodities including trading in the index components is speculative and can be extremely volatile and are not suitable for all investors. ETFs that are linked to an index composed of futures contracts on a single commodity or in only one commodity sector are less diversified than other ETFs. These funds can therefore experience greater volatility than other funds or investments. Investments in commodity-related companies may subject an investment to greater share price volatility than investments in traditional equity and debt securities. The commodity markets are considered speculative, carry substantial risks, and have experienced periods of extreme volatility. Investing in a volatile and uncertain commodities market may cause a portfolio to rapidly increase or decrease in value which may result in greater share price volatility.

An index is unmanaged and not available for direct investment.

S&P 500 Index is a market capitalization-weighted index composed of 500 widely held common stocks that is generally considered representative of the U.S. stock market.

S&P Goldman Sachs Commodity Index is a composite index of commodity sector returns representing an unleveraged, long-only investment in commodity futures that is broadly diversified across the spectrum of commodities. The returns are calculated on a fully collateralized basis with full reinvestment. The combination of these attributes provides investors with a representative and realistic picture of realizable returns attainable in the commodities markets.

NDR Commodity Composite measures a basket of commodity prices as well as inflation. It blends the prices obtain by George F. Warren & Frank A. Pearson, the purchasing manager index (PPI) and the Reuter’s Continuous Commodity Index. George F. Warren & Frank A. Pearson, former academics at Cornell, collected and published commodity price data over a period of time, from 1749 through 1932. The PPI measures the average changes in prices received by domestic producers for their output. The Thompson Reuters Equal Weighted Continuous Commodity Index comprises 17 commodity futures that are continuously rebalanced: Cocoa, Coffee Copper, Corn, Cotton, Crude Oil, Gold, Heating Oil, Live Cattle, Live Hogs, Natural Gas, Orange juice, Platinum, Silver, Soybeans, Sugar No. 11, and Wheat.

US Treasury Bill 90 days Index measures the performance of direct obligations of the U.S. Treasury. The returns shown are compiled from the yields available from the weekly auction of Treasury Bills with a maturity of 90 days.

Barclays US Long Government Float Adjusted Bond Index is a float adjusted version of the US Government Bond Index, which tracks the market for US dollar-denominated, fixed-rate, nominal US Treasuries and US agency debentures (securities issued by US government owned or government sponsored entities, and debt explicitly guaranteed by the US government). The index uses the same eligibility criteria as the US Government Index, but excludes US agency debentures held in the Federal Reserve SOMA account (both the flagship US Government Index and the float adjusted version also exclude Federal Reserve holdings of US Treasuries). To be included in the US Long Government Float Adjusted Index, securities must have at least ten years to final maturity.

Global Investment Strategy (GIS) is a division of Wells Fargo Investment Institute, Inc. (WFII). WFII is a registered investment adviser and wholly-owned subsidiary of Wells Fargo & Company and provides investment advice to Wells Fargo Bank, N.A., Wells Fargo Advisors, and other Wells Fargo affiliates. Wells Fargo Bank, N.A. is a bank affiliate of Wells Fargo & Company.

The information in this report was prepared by Global Investment Strategy. Opinions represent GIS’ opinion as of the date of this report and are for general information purposes only and are not intended to predict or guarantee the future performance of any individual security, market sector, or the markets generally. GIS does not undertake to advise you of any change in its opinions or the information contained in this report. Wells Fargo & Company affiliates may issue reports or have opinions that are inconsistent with, and reach different conclusions from, this report.

This report is not intended to be a client-specific suitability analysis or recommendation, an offer to participate in any investment, or a recommendation to buy, hold or sell securities. Do not use this report as the sole basis for investment decisions. Do not select an asset class or investment product based on performance alone. Consider all relevant information, including your existing portfolio, investment objectives, risk tolerance, liquidity needs, and investment time horizon.

Wells Fargo Asset Management (WFAM) is a trade name used by the asset management businesses of Wells Fargo & Company. Wells Fargo Funds Management, LLC, a wholly owned subsidiary of Wells Fargo & Company, provides investment advisory and administrative services for Wells Fargo Funds. Other affiliates of Wells Fargo & Company provide subadvisory and other services for the funds. The funds are distributed by Wells Fargo Funds Distributor, LLC, Member FINRA, an affiliate of Wells Fargo & Company.

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