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Talking Points: October/November 2010

Is it time to hop on the commodities bandwagon?

Morningstar Analysts, 10/11/2010

What Morningstar's analysts are hearing from mutual fund managers about commodities.

The Issues
It wasn't all that long ago that commodities barely registered for investors. These days, though, many investors recognize them as a valuable part of a diversified portfolio. Once considered a playground for traders and big institutions, a bevy of new funds and ETFs has made commodities more accessible than ever.

Some observers worry that commodities may become victims of their own popularity. An influx of cash from portfolio managers and ordinary investors, who previously trafficked in stocks and bonds, may have fundamentally altered commodities' behavior. Their returns now more closely track the stock market's, a trend that would diminish their diversification benefits if it persists. High demand has also distorted the futures market--a state known as contango--damping returns for those using futures to invest in commodities.

Fans of commodities concede that their returns have been more tied to the stock market than usual, but they argue that it is temporary and correlations remain relatively low. But even long-term believers say it may be best to wait for commodities to take a breather before diving in.

The Points
* Reflecting their increasing acceptance as a diversifier and inflation hedge, several major money managers, including Fidelity, T. Rowe Price, and Principal, either initiated or added to their target-date funds' commodities stakes in 2010, with most doing so through futures-based vehicles. T. Rowe Price, however, has opted for natural-resources stocks instead on worries that commodities futures won't be able to match past returns thanks to the contango phenomenon. Contrary to the conventional wisdom, T. Rowe says returns in most natural-resources sectors are far more sensitive to commodity prices than broad market benchmarks over longer periods.

* Not everyone has hopped on the commodities bandwagon: American Century opted against a permanent slot for commodities in its target-date portfolios, leaving it to the managers of the underlying holdings to invest in natural-resources stocks when they're attractive. It notes that the correlation between the S&P 500 and the S&P GSCI Commodity Index has clocked in at 0.4 during the past five years, well above the 20-year average of 0.1.

* Some notable managers recently pared their commodities exposure. The managers at PIMCO Global Multi-Asset PGAIX halved their stake in favor of equities. They're worried a deflationary, or at least a disinflationary, environment could be a headwind for commodities. Slowing growth in China, which has had a voracious appetite for commodities, could also reduce demand.

"Commodities, when they have their occasional 20% and 30% drops, use them, buy them. I don't think commodities are cheap right now. I think they will be in the next recession, which I don't think is that far off."
Rob Arnott, Research Affiliates

"We're adding commodities not for the efficient frontier but for inflation sensitivity in the 10 years prior to retirement."
Anne Lester, J.P. Morgan SmartRetirement funds

"Recently the correlation between equities and bonds has gone up, but we think it will go back down. Historically the correlation has been near zero and factors driving the market lately have been much more macro-themed. In a different environment, where, say, unexpected inflation dominates, you would see commodities have zero or positive correlation."
Christopher Burton, Credit Suisse


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