TradingKey - On April 2, President Donald Trump announced a reciprocal tariff plan, which had significant repercussions for global stock markets. Notably, commodities such as gold, steel, aluminum, and copper were excluded from this plan, making commodities an attractive investment option.

In the realm of investing, the pursuit of steady returns while effectively managing risk is a core objective for every investor. Today, portfolio diversification has become a consensus within the investment community, and commodities hold a unique and critical position in this diversified landscape.

So how can investors cleverly integrate commodities into their diversified portfolios to serve as both a robust engine for return growth and a solid shield against risk? This article will delve into these key insights.

If you want to incorporate commodities into a diversified investment portfolio, the first step is to understand the various pathways for commodity investment. So, what are the methods available for investing in commodities?

Spot Investment

This refers to the direct purchase of physical commodities, such as gold bars and silver ingots. The returns primarily come from price appreciation; when the prices rise, investors can profit by selling their physical assets. This method is particularly effective for preserving value during periods of inflation.

• Advantages:

Tangible Asset: Direct ownership of physical commodities can provide a sense of security.

Inflation Hedge: Commodities often maintain their value during inflationary times.

• Disadvantages:

High Storage Costs: Investors must consider costs associated with storage space, maintenance conditions, and insurance fees.

Poor Liquidity: The process of physical delivery and transactions can be complex and time-consuming.

Futures Investment

Futures investment involves trading commodity futures contracts on the futures market. Investors only need to pay a certain percentage of margin to control contracts with a much larger value. If their price predictions are correct, investors can achieve returns several times—or even more—than their initial investment.

• Advantages:

Leverage: The use of leverage allows investors to amplify potential returns. With a relatively small margin, they can control large positions in commodities.

Liquidity: Futures markets tend to be very liquid, allowing for easy entry and exit points for trades.

• Disadvantages:

Risks Amplified by Leverage: While leverage can boost profits, it also increases potential losses. If the market experiences unfavorable movements, losses can become significantly larger and may surpass the initial margin put in.

Delivery Risks: Futures contracts have expiration dates that require physical delivery or settlement. If an investor misjudges the market and fails to close their position before expiration, they may be forced into physical delivery, leading to increased transaction costs and risk.

Commodity ETF Investment

Commodity ETF (Exchange-Traded Fund) investment is a type of exchange-traded open-ended index fund that closely tracks the performance of commodity price indices or related indices. This investment method resembles stock trading and allows for real-time buying and selling on stock exchanges, typically at lower transaction costs; management fees usually range from 0.3% to 1%.

• Advantages:

High Liquidity: Commodity ETFs offer high liquidity, enabling investors to buy and sell quickly, which helps in capturing market opportunities promptly.

Lower Investment Threshold: The minimum investment required is relatively low—often just a few hundred or even tens of dollars—making it accessible for ordinary investors.

Simplicity: Trading commodity ETFs is straightforward and requires less logistical effort compared to directly purchasing physical commodities.

• Disadvantages:

Index Dependency: The returns on commodity ETFs are primarily tied to the performance of the tracked index, making it challenging for investors to achieve returns that surpass the index.

Tracking Error: Due to factors like fund management fees and the methodology used to replicate the index, there may be discrepancies between the net asset value of the fund and its benchmark index, leading to tracking errors.

Investing in Commodity-Related Stocks

Investing in commodity-related stocks involves selecting shares of companies that are closely linked to the commodity sector, such as those in oil extraction, mining, and agriculture. When these industries experience growth and commodity prices rise, the profitability of these companies typically increases as well, often leading to a rise in their stock prices. This investment strategy can offer investors the benefits of both capital growth and dividend earnings.

• Advantages:

Potential for Higher Returns: As commodity prices increase due to demand or supply constraints, the profitability of related companies often improves, leading to higher stock valuations and substantial returns.

Dual Benefit: Investors may reap both capital gains from the appreciation of stock prices and dividends from company profits.

• Disadvantages:

Price Volatility: Stock prices do not solely depend on commodity prices; they are affected by various factors, including company management effectiveness, industry competition dynamics, and broader macroeconomic conditions.

Complex Risks: While investing in related stocks offers more diversification compared to direct commodity investments, it introduces additional layers of risk. Factors such as operational efficiency, regulatory changes, supply chain disruptions, or market sentiment can impact stock performance independently of commodity price movements.

Commodity Fund Investment

Commodity fund investment can generally be categorized into two types: active management funds and passive index funds.

1. Passive Index Funds

These funds aim to replicate the performance of commodity indices, characterized by low transaction costs and high transparency. Investors can benefit from broad exposure to the commodity market without needing to actively manage their investment.

• Advantages:

Cost-Effective: Lower management fees compared to actively managed funds, usually due to less frequent trading and simpler operational structures.

Clarity: Investors find it straightforward to comprehend, as these funds aim to mirror a particular index, offering extensive market exposure without requiring extensive research.

• Disadvantages:

Limited Upside Potential: Returns are directly tied to the performance of the index; therefore, investors may miss out on potential gains if they could have chosen better-performing assets.

Tracking Error: There may be discrepancies between the fund's returns and the index it aims to replicate due to management fees and methodology in tracking.

2. Active Management Funds

These funds are managed by professionals who actively select investments based on market dynamics and their judgment. A skillful fund manager has the potential to yield superior returns through strategic asset allocation in various market conditions.

• Advantages:

Potential for Outperformance: If managed well, these funds can outperform standard benchmarks through informed investment decisions and tactical asset allocation.

Flexibility: Fund managers can adapt quickly to changing market conditions, repositioning portfolios as needed for optimum performance.

• Disadvantages:

Higher Management Fees: Active management typically incurs higher fees (usually between 1% - 2%), which can erode overall investment returns.

Dependence on Manager’s Skill: Fund performance is heavily reliant on the ability of the fund manager. Poor judgment or adverse market conditions can lead to underperformance relative to expectations.

Incorporating commodities into an investment portfolio leads to changes in risk primarily in two ways:

Firstly, including commodities can help lower correlation risk in the portfolio. This is because the price movements of commodities generally exhibit a low correlation with traditional assets such as stocks and bonds. For instance, commodity prices, like agricultural products, are influenced by factors such as climate and acreage, while energy prices are affected by geopolitical dynamics and global energy trends. These price fluctuations operate independently of the drivers impacting traditional assets like macroeconomic indicators, corporate earnings, and interest rate policies. Additionally, there are variations in correlation among different types of commodities themselves, which further lowers the overall correlation with traditional asset classes, thus providing a diversification benefit.

Secondly, incorporating commodities helps lower the overall portfolio risk through diversification. A portfolio's risk diminishes when there is a lower correlation among the assets. When a portfolio includes commodities, they can perform differently from traditional assets such as stocks and bonds during unfavorable market conditions; this can effectively cushion overall losses within the investment portfolio.

Market Risk and Policy Risk

Commodity prices are highly susceptible to various factors, including global economic conditions, political situations, policy changes, supply and demand dynamics, and natural disasters. Prices can be volatile with large fluctuations. Events such as changes in U.S. tariff policies or geopolitical conflicts (e.g., the Russia-Ukraine conflict) can significantly impact commodity prices. Therefore, investors must stay vigilant and continuously monitor these influences.

Transaction Costs

Investing in commodities involves several costs, including fees, margin requirements, slippage costs, and overnight holding costs. Different futures contracts and brokers have varying fee structures, and margin requirements can fluctuate based on market volatility and contract specifications. Investors should select trading platforms and products with lower transaction costs while appropriately managing trading frequency and holding periods to help minimize expenses.

Liquidity Risk

In certain niche markets or for rare metals futures, investors may encounter liquidity challenges, particularly when attempting to buy or sell large volumes of contracts. Therefore, investors should choose markets and trading products with good liquidity to ensure smooth transactions and avoid potential losses caused by liquidity issues.

Leverage Risk

Using leverage indiscriminately can increase risk exposure significantly. Investors should manage their leverage ratio prudently based on their risk tolerance and investment experience when determining how much leverage to use. Additionally, setting appropriate stop-loss levels is a vital strategy for controlling risks.

Common Misconceptions:

Misconception 1: Commodities Are Only Suitable for Short-Term Speculation

Some investors believe that the frequent and large price fluctuations of commodities make them suitable only for short-term trading to profit. However, commodities can also have long-term investment value. Take gold, for example; in a prolonged inflationary environment, it can effectively preserve and increase asset value, allowing long-term holders to benefit from its appreciation. Therefore, investors should assess their investment goals and risk tolerance and carefully balance their long-term and short-term investment proportions rather than limiting themselves to short-term speculative thinking.

Misconception 2: Blindly Following Trends Without Independent Judgment

Some investors lack independent judgment during the investment process and blindly follow market trends or others' investment advice. It is recommended that investors conduct thorough market research to understand the characteristics and risks of the assets they are investing in fully. They should develop investment strategies based on their individual circumstances rather than following the crowd.

Misconception 3: Fully Committing Capital Increases Risk Significantly

In pursuit of high profits, some investors opt to invest all their funds in commodities. This full commitment strategy carries extremely high risks. Given the volatile nature of commodity prices, if market movements contradict expectations, it may lead to significant losses or even complete liquidation for investors. Therefore, investors must remain rational, set appropriate positions, avoid chasing after market hype blindly, and refrain from over-leveraging by going all-in on bullish positions.