Futures and Commodities

Commodities are the basic goods that make up everyday life. They can include metals such as copper, gold and silver; energy sources such as crude oil and natural gas; agricultural commodities such as wheat and coffee; and livestock and meat products such as pork and cattle. Investing in commodities as an asset class, like equities or fixed income, is a way to potentially add diversification to an investment portfolio.

Investors can gain exposure to this asset class through direct investment in commodities or through commodity futures, as well as through mutual funds and exchange-traded products (ETPs)—including exchange-traded funds (ETFs), exchange-traded notes (ETNs) and ETPs using other structures such as commodity pools.

A direct investment in a commodity provides exposure to the performance of the commodity’s “spot,” or current price, and involves taking immediate delivery of or physically holding the commodity. This approach is less common with retail investors since it can also involve logistics such as transportation and storage, as well as insurance. With retail investors, direct investment in commodities is often in various precious metals such as gold and silver.

Commodity futures are derivative contracts in which the purchaser agrees to buy or sell a specific quantity of a physical commodity at a specified price on a particular date in the future. Derivatives are investments that derive their value from the price of another asset, typically called the underlying asset.

Commodity futures are most often traded by commercial enterprises that depend on commodities for their business activities. For example, your favorite cereal company might buy wheat futures to secure prices, while an airline might purchase energy futures.

Some sophisticated investors might also trade commodity futures, hoping to profit from changes in the price of a futures contract and never owning a contract when it comes due so they don’t have to deal in the physical commodity (such as accepting delivery of 40,000 pounds of cattle).

The Commodity Futures Trading Commission (CFTC) is the federal government agency that regulates the commodity futures and other commodity derivatives. By contrast, security futures are jointly regulated by the CFTC and the Securities and Exchange Commission (SEC).

Anyone who trades futures with the public or gives advice about futures trading must be registered with the National Futures Association (NFA). Before you invest in commodity futures, check to make sure the individual and firm are registered and whether they’re the subject of any disciplinary actions by using the NFA’s Background Affiliation Status Information Center (BASIC). NFA also offers a number of resources for investors to learn more about how the futures market works and the risks involved.

Commodity mutual funds and ETPs offer another avenue to investing in or tracking the performance of commodities and can help investors avoid the challenges or inconveniences of investing directly in physical commodities or futures. These products typically fall into one of two buckets:

• funds or products that invest in or track a wide variety of commodities or indexes and are registered securities that provide legal protections and ongoing disclosure about the investment; or
• commodity-oriented mutual funds and ETFs that focus their investment in securities issued by companies involved in mining, refining or development and other aspects of commodities-related business.

Either way, these products can provide a more accessible or cost-effective way to diversify among different types of commodities.

Some commodity futures-linked ETPs offer “geared” exposure, meaning they’re designed to provide returns that are leveraged (such as two- or three-times) or inverse (such as the opposite or twice the opposite) of the return of the commodity futures they track. This geared exposure is usually for a specific period, like one day or one month, and such products are generally not designed to be held for periods that deviate from that. Given the more volatile nature of some commodities and the additional complexities of the futures market, leveraged or inverse ETPs tracking commodity futures can present investors with heightened risks.

Bottom Line

Commodities can add diversification to an investment portfolio and might offer protection against inflation. However, commodity prices can be highly volatile, and investing in commodity futures and related products can carry significant risk. In particular, know what type of exposure your investment offers, and understand how exposure to futures can differ from exposure to the spot price of a commodity. The performance of a futures investment over longer periods can diverge, potentially significantly, from that of the spot price of the same commodity, and geared ETPs can also amplify that divergence.

Be cautious of claims that you can make large profits from trading futures. Although the high degree of leverage in futures can result in large and immediate gains, it can also result in large and immediate losses. As with any financial product, there’s no such thing as a "sure winner."

While commodity investing can open growth and diversification opportunities, be aware of the additional risks that come with it, and do your homework.

Futures Investment Risk

Rather than offering exposure to the spot price performance of a commodity, many popular commodity tracking products such as mutual funds and ETPs track futures on that commodity instead and are designed to provide continuous exposure over time. To do this, these products typically will track or hold futures contracts on a rolling basis, frequently focusing on shorter-term futures. This means that they’ll replace shorter-term contracts or contracts about to expire with others that have more distant or deferred expiration dates in order to maintain the desired exposure.

Rolling out of shorter-term contracts into longer-term contracts can, over time, lead to losses or gains—or worse or better performance relative to the commodity’s spot price—depending upon particular futures market conditions. Because of this, maintaining exposure through futures over longer time horizons can lead to a divergence in the performance of a futures-linked fund or ETP and that of the spot price, and in some cases that divergence can be significant.

Leverage Risk

Commodity investments often involve the use of leverage, which is borrowed money. This might be risky or expensive. You might pay a portion of the cost to invest in the commodity in cash but then pay for the rest of the investment "on margin." In some cases, this margined portion may be up to 80 percent of the purchase price. This is a loan that carries interest and is subject to the risk of a margin call if the value of the investment declines by a certain amount. In the event of a margin call, you might be required to invest additional money to prevent your investment from being liquidated without your consent or prior notice.

Liquidity Risk

Generally, you must enter into an offsetting transaction in order to liquidate a position in a futures contract. If you cannot hedge or liquidate your position, any existing losses may continue to mount. You might also end up having to accept physical delivery of the commodity, which would come with its own expenses and burdens. Even if you can close out your position, you might be forced to do so at a price that involves a large loss.

Risk of Investing in Commodity Products That Are Not Securities

Because they’re not securities, direct investments in commodities or commodity futures aren’t covered by the Securities Investor Protection Corporation (SIPC), which provides limited coverage to investors on their brokerage accounts if their brokerage firm becomes insolvent. However, mutual funds and ETPs offering exposure to commodities or commodity futures are typically registered as securities and so are eligible to be covered by SIPC. Learn more about SIPC protections.

Sociopolitical and Geopolitical Risk

Commodities investments can be impacted significantly by uncontrollable political and social events such as a terrorist attack, pandemic, election or climate of economic unrest. Weather events, too, can heavily affect prices of agricultural commodities, as can supply and storage availability with energy commodities. In addition, many commodities—especially those like precious metals, which may be mined in limited locations—are in conflict-prone regions and can be subject to geopolitical risk.

Risks Related to Commodity Mutual Funds or ETPs

Among ETPs providing access to commodity futures, several different product structures may be used—and these can have implications for investors with respect to regulatory protections, costs and tax treatment. Both mutual funds and ETFs that invest in commodity futures are typically registered with the SEC as investment companies. They often employ a subsidiary through which futures trading is done, which can simplify tax treatment for investors but also add some complexities.

On the other hand, many futures-tracking commodity-linked ETPs are structured as commodity pools or ETNs. While registered as securities and similar to ETFs, these different product types aren’t investment companies and so might offer less investor protection and have unique structural features that can introduce additional risks. This is also true for ETPs tracking the performance of precious metals like gold, which often invest directly in the physical metal and store it in vaults.

While such products can make commodity investing more accessible to investors, commodity funds and ETPs can be highly volatile, and performance may not track that of the underlying commodity. This volatility and risk can be further amplified if the products offer leveraged or inverse exposure.

The following resources can help you learn more about futures and commodities investing:

• FINRA:
  • Day Trading
  • Investor Insights: Golden Rules for Investors: What to Know Before Buying Physical Precious Metals
  • Investor Insights: Don't Be Crude: Know Your Oil Investment Vocabulary
• CFTC:
  • Customer Advisory: Learn About Risks Before Investing in Commodity ETPs or Funds
  • Commodity Pool Fraud
• NFA: Futures Fundamentals