Does a Commodity Investment Belong in Your Toolkit?

Question: A couple of years ago, it seemed that everyone was recommending that I put a small percentage of my portfolio in commodities to help fight against inflation. But lately I've been reading more about the how these funds haven't worked out as expected. So should I add commodities, or not?

Answer: Thanks for a timely question. Although there's a lot of research pointing to the beneficial effects of holding commodities in a portfolio, lately investors might be feeling like the current batch of commodity-focused products isn't quite ready for prime time.

I'll admit that I was a skeptic when financial-services firms and advisors began pushing commodities five or so years ago. Commodities enjoyed a stunning runup in the first part of this decade, and asset classes always seem to catch on as "must-have" only after they have enjoyed a big period of outperformance. Coincidence? I think not.

The Good�
True, there are a lot of data pointing to the long-term benefits of commodities as a portion of a long-term portfolio. For one thing, commodities--and here I'm talking about the prices of actual, physical stuff like metals, agricultural goods, and energy products--have a relatively low correlation with the price performance of traditional asset classes like stocks and bonds. That diversification ability, in turn, can improve a portfolio's risk/reward profile, even though commodity prices are extraordinarily volatile in and of themselves.

Moreover, commodities have the potential to provide at least some protection against the deleterious effects of inflation. As the prices you pay to buy food and put gas in your car move up, holding at least a portion of your portfolio in commodities--the prices of which would also be rising at that time--can help ensure that you actually benefit from those price gains. That inflation-fighting ability has been corroborated by several research papers, including this recent one in the Journal of Investing.

The Bad�
As compelling as the case for commodities is, however, it's tough for investors to obtain pure, unadulterated exposure to actual commodity prices.

Of course, the best way to make sure you receive the real, actual price performance of commodities would be to invest directly in them. That's the tack that funds like  SPDR Gold Shares (GLD) take: It buys gold bullion and then stores it. For gold and other highly valuable commodities, especially those where a relatively small amount can equal a high dollar value, taking physical ownership isn't an unreasonable or terribly unwieldy approach. But most investors seeking commodities exposure should strive for broad diversification among commodity types, and that's where the direct ownership idea gets unworkable. After all, the typical bank probably wouldn't look kindly on an investor--even a high-rolling mutual fund manager--trying to stash a truckload of pork bellies or barrels of oil on the premises.

In the past, the only alternative for those seeking broad-based exposure to commodity prices was to invest in the stocks of companies whose share prices are influenced by commodity prices, such as  ExxonMobil (XOM) or  Smithfield Foods . But company-specific noise can dilute the sensitivity of the stocks to commodity-price movements. Take  BP (BP) this past spring and summer, for example; the company's stock-price movements were a lot more sensitive to the fate of the Gulf oil spill than oil prices.

The commodity-focused funds and exchange-traded funds that have launched during the past decade and a half do stock-focused funds one better, at least in theory, by investing in commodity futures. That should provide more direct commodity-price exposure than you'd obtain by investing in the common stocks of commodity-focused companies. In practice, however, futures-based strategies haven't fully reflected commodity prices, a state called contango. Terms like contango and backwardation might make your eyes glaze over (though my colleague Paul Justice provides a clear discussion here). But the bottom line is that as futures-based strategies have grown in popularity and demand for financial exposure to commodities has dwarfed demand for actual, physical exposure to them, commodity futures contracts have been increasingly out of sync with actual commodity prices.

And the Bottom Line
So what's a well-meaning investor to do? There are a few different possibilities, none of them perfect.

One idea would be to invest in a futures-based commodity ETF or mutual fund and live with the fact that it might not be a pure reflection of commodity prices at any given point in time. My advice would be to keep it to a relatively small slice of the portfolio--Morningstar's Lifetime Allocation Indexes put the optimal percentage at roughly 4%-6% for investors at most life stages--and dollar-cost average into the position to mitigate the chance of buying in at an inopportune time. (As I discussed in this article, bad timing can erase the benefits you were hoping to obtain by buying a commodities investment in the first place, especially if you're retired and don't have a good, long while to recoup your losses.)

Alternatively, an investor could go the direct route by investing in a gold or precious metals fund that owns its metals straight-up. That's the tack favored by my ETF colleagues, who hold  iShares Gold Trust (IAU) in the Hands-Free Portfolio they run in Morningstar's ETFInvestor newsletter. But what I just said about dollar-cost averaging into commodities applies doubly so (and then some) for would-be gold investors, given the heights the metal has scaled in recent years.

Another avenue is to forgo direct commodities exposure and instead rely on traditional asset classes such as Treasury Inflation-Protected Stocks and common stocks to help deliver at least some of the benefits that commodities bring to the table. For example, broad stock market indexes hold upward of 10% in energy producers, and TIPS have explicit inflation protection. The obvious downside is that investors taking this route won't benefit directly from commodity-price movements and the diversifying effects they can provide. The advantage of this approach is that it's simple and low-cost, and implementing it may require limited effort, as such asset classes are probably already in your portfolio.

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