What is... | February 28, 2012

What is a commodity?

Commodities form an essential part of our daily lives as they are used in food, construction, energy and transport. Prices of commodities rise and fall just like share, bond and property prices.

Changes in commodity prices have a direct impact on households as they can lead to a fall or rise in the cost of living. Changes in the price of petrol and food are often driven by changes in commodity prices.

Commodities as investments
Commodities also offer investment opportunities. However commodities are generally seen as more suitable for investors who are willing to take high levels of risk.
Commodity prices can be more volatile than other investments because their markets can be smaller and more specialised and they can be affected by unpredictable factors, such as the weather, that can quickly alter the supply of the commodity.
It has also be argued that herd behaviour and animal spirits play a larger role in commodity than in other markets, inducing bubbles and collapses.

Hard and soft
To an economist a commodity is defined as something that can be produced by different companies and is almost identical. Products that are very similar but not identical are not commodities. For example, oil, wheat and iron ore are commodities while pairs of jeans are not.
Commodities generally fall into categories. Hard commodities include metals while softs include foods and industrial inputs such as wool. They can be divided according to use such as energy commodities, or by value such as precious metals like gold.
Commodity prices are set in major commodity exchanges such as the Chicago Mercantile Exchange, the London Metal Exchange and the IntercontinentalExchange by buyers, sellers and investors using brokers to carry out transactions.
Prices of different commodities move at varying speeds and directions according to different factors. Soft commodities may be affected by the weather while the oil price may move on changes in global demand and factors that may affect supply such as wars and political tension.

Mutual friends
Few household investors buy actual physical commodities as an investment. The easier option is to invest in a commodity mutual fund or an exchange traded fund (ETF).
Mutual funds and ETFs allow people to invest in the same way as with shares and bonds. Depending on the fund, investments can be made in individual commodities or in an index consisting of several commodities.
As with other funds, investors must choose whether to buy an active fund that relies on the skill of a fund manager to outperform a particular benchmark or a passive fund that tracks the market. Each approach has its pros and cons.
An important difference with investing in commodities is that, unlike shares, which pay a dividend, and savings accounts and bonds that pay interest, commodities do not pay regular income. Interest earned and dividends reinvested can play an important part in generating returns for investors.

Growing a hedge
Commodities are often seen as a hedge against inflation. But a 2009 IMF study found that while commodities were the best hedge over the short term, long-term effects of inflation caused commodity prices to fall gradually over time.

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Phil Thornton
Phil Thornton

Lead consultant at Clariti Economics