How to Use Commodities in Your Portfolio
In this series on portfolio basics, I’ll explain some of the fundamentals of putting together sound portfolios. I’ll start with some of the most widely used types of investments and walk through what you need to know to use them effectively in a portfolio.
What Are Commodities?
Commodities are typically defined as raw materials or basic agricultural products that are interchangeable with other products of the same type. Some of the most common types of commodities include energy (such as crude oil, natural gas, and gasoline), metals (such as gold, silver, copper, and platinum) and agricultural goods (such as corn, wheat, soybeans, and coffee). Commodities can be both traded and used as investment assets, either through direct ownership, futures contracts, or commodity-focused funds.
In this article, I’ll focus mainly on indexes based on commodity futures, as well as funds and exchange-traded funds that focus on commodities. Another note: I covered gold in another edition of Portfolio Basics, but gold is also a commodity and currently makes up about 14.3% of the Bloomberg Commodity index.
As the graph above illustrates, commodities have not had impressive long-term performance. Since 1991, the Bloomberg Commodity Index has fallen behind most other major asset classes and barely pulled ahead of cash and inflation. Commodities fared better during the 1970s and 1980s. The S&P GSCI index, which has a longer track record but has heavy weightings in energy-based commodities such as crude oil and natural gas, generated annual returns of about 21.3% in the 1970s and 10.7% during the 1980s. The S&P GSCI benchmark posted returns of about 6.7% per year, on average, over the period from 1970 through 2024.
Compared with other asset classes, commodities tend to go through longer periods of outperformance and underperformance, known as supercycles. For example, commodities fared relatively well for most of the period from 1991 through mid-2008, as rapid economic growth in China boosted demand for oil, metals, and agricultural commodities. Since then, commodities have often lagged, although they fared well when inflation spiked in 2021 and 2022.
The difference between spot prices and futures prices for a given commodity (which creates “roll yield”) can also have a major impact on longer-term returns. If futures prices are higher than spot prices (known as contango), this dynamic creates a drag on returns because commodity buyers are forced to sell expiring contracts at a lower price and buy new contracts at a higher price, creating a negative roll yield. In the opposite case (known as backwardation), investors can pick up a positive roll yield as they sell at a higher price and then buy at a lower price.
What Are the Advantages and Risks of Investing in Commodities?
Because of these dynamics, commodities have posted lackluster returns over the past 20 years. At the same time, commodities’ volatility has been a bit higher than that of large-cap stocks, which have generated much more robust returns.
Commodities have also been subject to painful levels of downside risk. During the past 20 years, for example, the benchmark lost about 72% between mid-2008 and early 2020 mainly because of weakness in crude oil and natural gas.
How to Invest in Commodities
There are several ways to invest in commodities: buying the physical commodity directly, buying stocks of commodity producers, purchasing futures contracts, or investing in funds or ETFs that buy commodity futures. While many investors own gold in physical form, it’s usually not practical to purchase other commodities directly because of the storage costs involved. Buying stocks of commodity producers involves an additional risk because they’re leveraged to the price of the underlying commodity. Purchasing mutual funds or ETFs that buy commodity futures is the easiest way for the average investor to gain exposure to commodities.
There are roughly 60 funds available that focus on single commodities, but funds that hold a broader range of commodities are a safer bet.
The table below shows several funds in the commodities broad basket Morningstar Category with above-average Morningstar Medalist Ratings.
Diversified real asset funds—which typically invest in commodities as well as other inflation-sensitive assets such as Treasury Inflation-Protected Securities, and both stocks and bonds in sectors such as real estate, energy, and basic materials—are another option for commodity exposure.
The table below shows several real asset funds with above-average Morningstar Medalist Ratings.
When Do Commodities Perform Best?
Despite their short-term volatility, commodities can add value at times, particularly during periods of high inflation.
The table below shows annualized returns for commodities during some of their strongest periods.
How Long Should I Hold My Investments in Commodities?
Morningstar’s Role in Portfolio framework recommends holding commodities for at least 10 years. We came up with this guideline partly by looking at the historical frequency of losses over various rolling time periods ranging from one year to 10 years. We also considered the maximum time to recovery, or how long it usually takes to recover after a drawdown.
How Much of My Portfolio Should Be in Commodities?
As with other specialized fund categories, Morningstar’s Role in Portfolio framework recommends that individual investors keep their commodities exposure limited (which Morningstar defines as 15% of assets or less). Given their on-and-off performance record, though, most investors will probably want to keep their exposure even lower (5% to 10% or less of the total portfolio value is a reasonable guideline).
As discussed above, commodities have not generated impressive long-term returns, although they can fare well in certain periods. In addition, commodities can provide significant diversification benefits, as their correlation with stocks, bonds, and other asset classes is typically very low.