A Beginner's Guide To Investing In Commodities With Fidelity

Investing in commodities can be a great way to diversify your portfolio and hedge against inflation. Commodities are raw materials that are either consumed directly or used as building blocks to create other products. There are several ways to invest in commodities, including purchasing physical raw commodities, using futures contracts, or investing in exchange-traded products (ETPs) that track a specific commodity index. One popular way to invest in commodities is through commodity ETFs, which offer easy and inexpensive access to various commodities markets. These ETFs may contain precious metals, oil and natural gas, or agricultural products. It's important to note that investing in commodities comes with risks, as commodity prices can be extremely volatile and affected by various factors such as world events, import controls, and economic conditions.

Commodity stocks vs. commodities

Commodities are raw materials that are either consumed directly, such as food, or used as building blocks to create other products. Commodities can be further classified into two types: hard and soft commodities. Hard commodities are usually classified as those that are mined or extracted from the earth, such as metals, ore, and petroleum products. Soft commodities, on the other hand, refer to those that are grown or ranched, such as agricultural products. Examples of hard commodities include gold, crude oil, copper, and natural gas, while soft commodities include rice, wheat, soybeans, and cattle.

Commodity stocks, on the other hand, refer to the stocks of companies that are involved in the production, transportation, and storage of commodities. For example, an oil and gas fund would own stocks issued by companies involved in energy exploration, refining, storage, and distribution.

There are several differences between investing in commodity stocks and investing directly in commodities. One key difference is that commodity stocks and commodities do not always deliver the same returns. There are times when one investment outperforms the other, so maintaining an allocation to each group might help contribute to a portfolio's overall long-term performance. Over time, commodities and commodity stocks tend to provide returns that differ from other stocks and bonds, which can help investors better manage market volatility.

Another difference is that individual commodity prices can be extremely volatile and are influenced by various factors such as supply and demand, exchange rates, inflation, and the overall health of the economy. The commodities industry can also be significantly impacted by world events, import controls, worldwide competition, government regulations, and economic conditions. In contrast, commodity stocks may be less volatile and risky compared to investing directly in commodities.

Additionally, investing in commodity stocks provides partial ownership of the company, while investing in commodities does not provide an actual equity stake. Instead, investors have the right to buy or sell the commodity at a future date through instruments such as futures contracts.

When deciding whether to invest in commodity stocks or commodities, it is important to consider your investment goals, risk tolerance, and market knowledge. Commodities can act as a hedge against inflation and offer high returns during market volatility, but they are often more speculative. Stocks, on the other hand, generally provide long-term growth potential and may generate dividends, making them suitable for building wealth over time. A balanced investment approach may involve a mix of both, depending on your investment strategy.

Mutual funds or exchange-traded products (ETPs)

Mutual funds and exchange-traded products (ETPs) are two popular ways to gain exposure to the commodities market. Mutual funds invest in commodity-related businesses, such as an oil and gas fund that owns stocks in energy exploration and distribution companies. On the other hand, ETPs track a specific commodity index or sector and are generally considered more complex and volatile investments.

Commodity-based ETPs can be further categorized into physically-backed funds, exchange-traded notes (ETNs), and futures-backed funds. Physically-backed funds actually own the underlying commodity, such as gold bullion. Exchange-traded notes (ETNs) are unsecured debt instruments issued by banks, designed to match the returns of the underlying asset. Lastly, futures-backed funds gain exposure to commodities through futures contracts, forward contracts, and swaps.

When investing in mutual funds or ETPs, it is essential to consider the risks and volatility associated with commodities. The commodities industry is susceptible to world events, government regulations, economic conditions, and other factors that can impact prices. Additionally, mutual funds or ETPs that track a single sector or commodity can exhibit higher-than-average volatility.

Before investing, it is crucial to understand the investment objectives, risks, charges, and expenses associated with mutual funds and ETPs. Making informed investment decisions involves carefully reviewing the fund's prospectus or offering circular to ensure alignment with your financial goals and risk tolerance.

Commodity-based ETFs

Physically-backed funds, as the name suggests, actually own the underlying commodity. For example, investors in the SPDR Gold Trust gain an ownership stake in the fund's stockpile of gold bullion without the hassle of storing and insuring physical gold. However, physically-backed ETFs are taxed the same as an investment in the metal itself, with a rate of up to 28% for long-term holdings.

Equity-based commodity ETFs offer exposure to commodities through the stocks of companies involved in the production, transportation, and storage of natural resources and raw materials. These funds are treated like stocks for tax purposes, making them more suitable for short-term investors. For example, the VanEck Gold Miners ETF provides exposure to companies involved in gold mining.

Futures-backed commodity funds use futures contracts, forward contracts, and swaps to provide exposure to the targeted commodity. These funds can influence futures prices and may be subject to regulatory restrictions. They have unique tax implications, with 60% of gains taxed at the long-term capital gains rate of 20%, and the remaining 40% taxed as ordinary income.

ETNs are unsecured debt instruments linked to various assets, including commodities and currencies. They offer more favourable tax treatment than commodity ETFs, with a 20% capital gains tax after holding for more than a year. However, ETNs carry the credit risk of the issuing bank.

When choosing a commodity-based ETF, investors should carefully consider the fund's objective and how it achieves exposure to the desired commodity. The tax implications and risks associated with each type of ETF should also be considered to make an informed investment decision.

Equity-based commodity exposure

Equity-based commodity ETFs offer investors "leverage-like" exposure to commodities through the stocks of companies involved in natural resources and other raw materials. This method of investing in commodities is a viable alternative to futures-backed ETFs, which may be subject to trading limits and other regulatory restrictions. Equity-based commodity ETFs also have better tax implications than ETFs that hold physical stockpiles of precious metals.

Equity-based commodity funds are a safer way to gain exposure to commodities, minimising the risks associated with physical and futures commodity ETFs. This is because they offer passive investing and economies of scale, which may provide lower expense ratios. However, investing in equity funds adds a layer between the investor and the commodity.

For example, investors looking to gain exposure to gold can find equity-based alternatives such as the VanEck Gold Miners ETF and the VanEck Junior Gold Miners ETF. The former provides exposure to worldwide companies that are involved primarily in mining for gold, including large-, mid-, and small-cap stocks. The latter tracks small- and mid-cap companies involved in gold and/or silver mining. Both funds are treated like stocks for tax purposes, which makes these funds more suitable for short-term players in the gold market.

In summary, equity-based commodity exposure is a good option for those seeking to minimise risk and cost when investing in commodities.

Futures-backed commodity funds

The Commodities Futures Trading Commission (CFTC) proposed position limits on futures contracts, which forced some of these funds to create new mechanisms for tracking their underlying commodities. This was done out of fear of the possibility of commodity bubbles.

Futures-based funds have unique tax implications. 60% of any gains are taxed at the long-term capital gains rate of 20%. The remaining 40% is taxed at the investor’s ordinary income rate, regardless of how long the shares are held. This comes out to a blended maximum capital gains rate of 28%.

Compared to physically-backed funds, futures-backed funds may offer certain advantages. However, those advantages come at a cost: namely, tracking discrepancies with the underlying commodity, regulatory risk, and potentially even credit risk.

Commodity-related businesses, such as an oil and gas fund, would own stocks issued by companies involved in energy exploration, refining, storage, and distribution.

Frequently asked questions