Why Some Investors Hedge with Commodities

Ahead, we’ll take a closer look at the role of commodities in hedging portfolio risk. 

Hedging portfolio risk

Equity-bond portfolios generally aren’t well protected against stagnant economic growth and elevated inflation in two situations in particular:

• when global policy uncertainty is elevated (e.g., markets debating the central bank’s ability to contain inflation), and
• when the economy is hit by a supply shock (such as a sudden interruption in energy supplies).

This is why some investors may choose to diversify into commodities.

For example, gold prices jumped in the 1970s as pronounced spending by the US government and reduced central bank credibility stoked inflation. “Gold surged as investors sought value outside the system,” Goldman Sachs Research analyst Lina Thomas writes in the team’s report.

More recently, commodities were among the few assets to rise (in inflation adjusted terms) when Russia cut its gas flows to Europe in 2022.

Commodities could protect portfolios against trade volatility

Thomas points out that commodity supplies are becoming more concentrated and countries are using their control over resources as geopolitical leverage. Commodities are likely to have a more strategic role going forward, according to Goldman Sachs Research, with government control fluctuating in a four-step cycle:

1. Governments insulate supply chains by reshoring production through tariffs, subsidies, and investment—replacing imports where possible and stockpiling commodities where it’s not.
2. Once domestic supply expands and is secured, surplus production is exported.
3. As global commodity prices fall, higher-cost producers exit, and supply concentrates among fewer producers.
4. As supply consolidates, dominant producers are able to use it as geopolitical and economic leverage via tools such as export restrictions—raising disruption risk and eventually prompting other countries to again insulate their supply chains.

There are several examples of commodity and resource concentration taking place now. The US is likely to provide more than a third of the global supply of liquified natural gas (LNG) by 2030, and the country has linked those exports to tariff negotiations. Europe, in particular, has shifted toward US LNG and away from Russian gas since 2022. The share of gas supplies provided by the US in Europe and Asia is expected to climb further.

China, meanwhile, controls more than 90% of the refining capacity for rare earth minerals. These elements are essential in the race to develop artificial intelligence.

“The growing use of commodities as leverage may reinforce the diversification benefits of commodities in portfolios,” Thomas writes.

Not all commodities create an equal hedge for portfolios

Determining their effectiveness requires understanding if a particular commodity is likely to be part of a critical supply disruption and whether that disruption is inflationary, according to Goldman Sachs Research. Two criteria must be considered: 1) the commodity’s direct or indirect weight in the inflation basket and 2) the share of supply being disrupted.

Energy, for example, meets the first criteria, as disruptions can rapidly impact economies and financial markets.

The direct weight in the inflation basket of industrial metals and rare earth minerals ranks lower, though their influence has been rising as the energy mix shifts from fossil fuels to renewables that use these commodities.

Industrial metals and rare earths stand out because refining is highly concentrated in China. As a result, even with only an indirect impact on inflation—such as the cost of electric vehicle batteries—a disruption could have an outsized effect.

Potential risks to consider

Though commodity investing could provide diversification and hedging opportunities as part of a balanced portfolio, it may not be appropriate for every investor—especially individuals who are new to investing or have a low tolerance for risk.

First, while diversification has the potential to help manage volatility and smooth out returns over time, it cannot guarantee gains nor protect you from losses.

Second, as with traditional securities like stocks and bonds, investing in commodities involves risk. Commodity assets are subject to higher volatility, as their prices are subject to economic, regulatory, and geopolitical conditions. Agricultural commodities may also be impacted by natural events (e.g., climate, disease, etc.).

In short, you could make money or lose money, including your principal. If you’re interested in investing in commodities, it’s a good idea to consult your investment or wealth advisor to understand the risks and whether it makes sense for your investment goals.