Commodity funds are potentially rewarding, way to diversify your investment portfolio beyond stocks and bonds. We have seen huge rises in commodities prices in recent years, as the demand for raw materials and food products has soared from countries such as China.
What are Commodities?
Typically, commodities are defined as things that come from the earth or are grown. This includes grains, minerals and metals, livestock, cotton, oils, sugar, coffee, and cocoa. Some of the more common commodities traded on the exchange include crude oil, hog bellies, cattle, and wheat.
Commodities are traded in the spot market, or in the form of futures contracts. Spot market trades are made for immediate delivery. For example, energy could be traded on the spot market, and delivered immediately into the electrical network. When trading on the spot market, physical delivery of the commodity often takes place.
Commodity Futures
Commodities traded as futures are contracted for a “future” delivery date. Most investors in the commodity market trade in futures contracts, and many of these contracts are sold before the contract expires. That means the average investor never takes physical delivery of the commodity itself, rather they are looking to make money on their investment through the changes in the commodity’s value over time.
Commodities as a Hedge Against Inflation and Stock Market Declines
Commodities are often used as a hedge against inflation, since the prices of commodities tend to rise in line with inflation. This movement also generally tends to run counter to share prices, which is a characteristic which makes commodity funds an excellent way to diversify your investment portfolio, and which is attractive to many investors.
The market price of most stocks goes down when inflation is rising. There are several explanations for this, but the simplest has to do with the cost of borrowing. Inflation is usually associated with higher interest rates, and this makes borrowing more costly for a company. In turn, the increase in interest expense lowers earnings per share. Thus some exposure to commodities may help to offset any losses from equity investments.
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