Should You Add Commodities to Your Investment Mix?

Anyone who has been paying even mild attention to the financial markets over the past few years has probably noticed the stunning gains in commodities markets. Perhaps not surprisingly, investors are increasingly seeking out investments in commodities, and there are more mutual funds than ever before in the marketplace that provide exposure to these types of investments.

Let's preface this discussion by saying that, as a general rule, we at Morningstar seldom endorse performance chasing--that is to say, jumping into a hot asset class. All too often, it simply works out badly for investors. As Morningstar's director of fund analysis Christine Benz pointed out last month, one of the biggest mistakes investors routinely make is flocking to hot-performing investments because they expect that the good times will keep on rolling, when all too often the opposite happens. By the time investors buy into that sizzling fund, it's ready to cool off, usually because the type of securities it buys are more expensive than they once were and therefore have a lot less room to move up in price. That said, the potential portfolio diversification benefit from commodities could be a compelling reason for a risk-tolerant investor to allocate a small portion of her or his portfolio to the asset class. Before you do so, however, take time to consider the pros and cons.

What Are the Potential Benefits?
Commodities tend to bear a low or, depending on which data and time periods you look at, even negative correlation to other types of financial assets (namely, stocks and bonds). Essentially, this means that when stocks are rising, commodities tend to retreat, and vice versa. The low correlation between commodities and stocks is a trend that is well established over long time periods--many correlation studies span 30 years or longer. (For more on this subject, see the related readings at the end of this article).

In addition, commodities exposure can also help offset the deleterious effects of inflation. Put simply, inflation weighs down stocks and bonds, over both short and long time periods. So, for example, when Federal Reserve Chairman Ben Bernanke says that inflation is a near-term economic concern, his remarks are usually followed by a decline in the share prices of stocks and bonds. That's because investors expect higher interest rates, which, in turn, could crimp stock and bond prices. But these are usually just short-term sell-offs; investors usually jump back into the markets when the near-term inflation picture looks rosier. A bigger concern is the long-term effects of inflation. Over the long term, inflation can eat into an investor's nominal return. (Real return is the nominal return of an investment minus inflation). To use a very simplified example, let's say you invested $1,000 in a 10-year Treasury note that pays a 6% yield. At the end of 10 years, your nominal return would be $1,600--your principal, $1,000, plus $600 in yield. Now, factor in the costs of inflation: Let's say inflation increased 4% over a period of 10 years. That means that at the end of 10 years, your real return would be only $1,200--$1,600 minus $400 eaten by inflation.

On the other hand, commodities often benefit from inflation over the short term and long term, because when the price of goods and services increases, the prices of the commodities needed to produce the goods and services will subsequently increase. And when prices are increasing, producers are compelled to supply more, so more commodities are needed to meet increased demand for raw goods. Of course, there are exceptions: Gold markets also benefit from inflation, but not because gold has any practical use in manufacturing. When the economy struggles, in times of geopolitical uncertainty, or when monetary problems erupt, gold prices have historically risen--sometimes dramatically--as consumers and institutions demand and hoard more, perceiving it as a "safe haven," or a true store of value.

What Are the Risks?
Make no mistake: Despite their potential benefits, commodities are not a silver bullet. Commodities are one of the most volatile asset classes available. How volatile?  PIMCO Commodity RealReturn , a fund that invests in derivative instruments that seek to replicate the performance of the Dow Jones-AIG Commodity Index, has a standard deviation of 15.29. For context, that's about twice as volatile as an S&P 500 Index fund and nearly four times as volatile as a fund that tracks the Lehman Brothers Aggregate Bond Index. Put simply, that means that just as surely as the commodity markets can put up stunning gains, they can take some heart-wrenching stumbles--look at 1998, for example, when the Dow Jones-AIG Commodity Index lost 27%. Before you take the plunge into commodities today, it's important to ask yourself if you would truly hold onto that commodities investment if commodities prices swooned over the next few years. If you sold instead of sitting tight, you'd wind up looking like the aforementioned performance-chaser who bought high and sold low.

But volatility is not necessarily a bad thing, especially in the context of a diversified portfolio. Because commodities' returns tend to be negatively correlated with other asset classes', when commodities funds are on the upswing, they can significantly offset losses in other parts of a portfolio. Because the gains and losses are so magnified, we wouldn't recommend allocating any more than 10% of a portfolio to commodities--closer to 5% seems reasonable to us.

In addition, it's a misconception that the asset classes will always move in opposite directions. Many investors sat up and took notice of commodities in 2002, when the Dow Jones AIG Commodities Index soared almost 26%, while the S&P 500 Index sank more than 22%. That one year of markedly divergent performance aside, commodities and stocks have been moving in the same direction lately. In 2003 and 2004, the Dow Jones AIG Commodities Index returned 24% and 9%, respectively, but the S&P 500 outpaced the index's return by a few percentage points in both years. It certainly stings investors less when both asset classes are gaining rather than losing ground, but the latter happens too: In 2001, the Dow Jones AIG Commodities Index lost more than 19%, while the S&P 500 lost around 12%.

Finally, to get the full benefit of diversification, investors should maintain that small allocation to commodities over a long time period, maybe 10 years or longer, depending on one's investment time horizon. That means riding out the highs, and not running for the hills during the lows. Next week I'll discuss the best ways to obtain exposure to commodities.

Related Readings
"The Case for Commodities"
by Curt Morrison, Equity Analyst, Morningstar

"Should You Invest in Commodities Funds?"
by Karen Dolan, Fund Analyst, Morningstar

"Strategic Asset Allocation and Commodities"
Study prepared by Thomas M. Idzorek, Director of Research, Ibbotson Associates