Commodities: should you invest in chocolate and coffee?

Commodities are overshadowed by the stock market in the minds of most investors, but there are good reasons to factor them into your thinking.

They can significantly enhance a portfolio by diversifying the assets within it, and at times they outperform stocks in terms of returns.

From crops like cocoa, coffee and wheat, to metals such as zinc and copper, as well as fuels including crude oil, commodities have a lot to offer investors.

Here we explore:

• What are commodities?
• What determines commodities prices?
• What are the pros of investing in commodities?
• What are the cons of investing in commodities?
• How can I invest in commodities?

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What are commodities?

Commodities are made up of three broad categories: foods, metals and fuels. They include cocoa, coffee, corn, cotton, wheat, sugar, cattle, copper, zinc, nickel, gold, silver, platinum, oil, gas and coal.   

In an investment context, we are usually talking about financial instruments tied to the underlying commodities rather than the commodities themselves. This is because transporting and storing large quantities of a commodity is impractical for most investors, and very expensive. 

Precious metals such as gold are sometimes considered a distinct asset within the wider commodities banner and can be an exception. However, even those are much easier to invest in via a financial instrument than through physical ownership.

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What determines commodities prices?

As with any freely traded asset, the balance between supply and demand sets the price. The factors which play into these two things are different to stocks and bonds.

In the case of food commodities, for example, prices are often linked to the weather. This is because it is the major factor in determining the size and quality of the harvest. A poor harvest restricts supply and puts upward pressure on prices, while a relatively successful, large harvest does the opposite. 

Geopolitics

Geopolitics, or to put it more starkly, wars, can have an outsized impact on commodities relative to stocks and bonds. Oil is perhaps the prime example, with prices fluctuating wildly when armed conflict flares up in oil-producing places such as the Middle East.

An armed conflict can dramatically squeeze supply due to the impact on production and transportation of a particular commodity. 

Labour issues are another potential factor, with union disputes, strikes or shortages of workers to produce the commodity sometimes having an impact.

On the demand side, the companies that use the commodities to deliver products can vary the amount they wish to acquire from year to year. This depends on many factors including industry-specific trends and the strength of the wider economy.  

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What are the pros of investing in commodities?

The principal reasons for investing in commodities are the potential for good returns and diversification. 

When there is a spike in demand for a commodity or a large drop in supply, the price jumps. Being able to anticipate such things is far from easy, though. A recent example is cocoa, the key ingredient in chocolate products. The price climbed steeply in March 2024 due to a drop in supply from major cocoa producers in West Africa. 

Diversification is the other main reason for including commodities in an investment portfolio. Good investors will typically want to hold baskets of assets that don’t all rise and fall at the same time, in order to smooth out the performance of their portfolio as a whole.

Adding commodities to a portfolio of stocks and bonds can help in this regard, as commodities tend to move independently and differently to these asset classes.  

That is not always the case, and everything can rise or fall together in some circumstances, but it has been consistently evident over time. This is called being decorrelated. 

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What are the cons of investing in commodities?

The potential for sharp rises in price is very much a double-edged sword, because there is always the possibility of large falls as well. Volatility in the price of some commodities makes them unsuitable for novice investors and those with low-risk appetites who are not comfortable with large falls in the values of their holdings. 

Another downside is that because most investors can’t take possession of the underlying commodities, they rely on an investment firm to act as a counterparty. This creates a second layer of risk as the end investor is reliant on the provider of an exchange-traded commodity (ETC) or exchange-traded fund (ETF) to properly back the shares and not go out of business. 

An additional issue is that investing in commodities profitably requires following geopolitical events and macroeconomics closely, as well as understanding their implications. This is not something all investors are necessarily well positioned to do.  

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How can I invest in commodities?

There are multiple ways to invest in commodities, with both passive and active options.

Passive investments simply track the price of the commodities and your returns will be very close to the performance of the commodities you invest in.

A common way to do this is through exchange-traded commodities (ETCs). An ETC provider will acquire the underlying commodity, such as copper, and issue shares against it. The end investor simply has to buy and hold the ETC shares via their platform or broker in the same ways as company stocks.

Although they are bought and sold like shares, they are actually structured as asset-backed bonds. In other words, they represent a debt obligation to the issuer. 

Similarly, exchange-traded funds (ETFs) can offer exposure to commodities. An ETF will usually be backed by a basket of different commodities rather than a specific one.   

There are also commodities futures and swaps available through some trading platforms, which allow speculation on the prices both to the upside and downside. These are financial instruments designed to offer exposure to price movements without holding the underlying assets. These are only suitable for advanced investors. 

Active funds

It is possible to take an active approach to commodities investing by buying into an actively managed commodities fund or investment trust. A fund manager or team will select the commodities they believe will perform best according to the fund’s stated aims. They may also invest in companies which are involved in commodities production.

While they are unlikely to invest in all commodities, they will typically hold a broad basket. The relative weightings to each commodity within the fund will be chosen by the managers, as well as which ones are included. The managers will aim to outperform a relevant passive benchmark, in exchange for an ongoing fee. 

Finally, there is physical possession. As discussed earlier, only large investors will consider this as there is a lot of money, expertise and connections required to buy and store large amounts of a physical commodity.

Precious metals are the only commodity that it can be feasible to take physical possession of in relatively small quantities.

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