Commodities: Whether, What, and How Much?

Commodities investors have been on a roller coaster ride lately. After posting very strong gains for most of the year, commodity prices pulled back sharply during the past week, with oil and silver leading the way down.

Amid a herky-jerky commodity-price landscape, are Morningstar.com users viewing commodities as must-have or must-avoid investments? And among those who have embraced commodities, have they employed them as long-term portfolio components or are they using them more tactically, as a way to bet on higher overall prices or the direction of a single commodity?

To find out, I recently surveyed our users, posting a query on the Portfolio Design/Management forum on Morningstar.com's discussion boards. Perhaps not surprisingly, given that falling commodities prices dominated the headlines last week, users weighed in at a furious pace. Their posts showcased a wide range of opinions, ranging from folks who are avidly buying and selling commodities to those who are unconvinced of the long-term merits of the asset class.

To read the complete thread or contribute your own views, click here.

A Long-Term Strategic Hedge
A small segment of users is employing commodities in a tactical role, jumping in and out based on short-term trends. The majority of posters who said they're using commodities, however, are buying broad-based commodities investments as a long-term hedge against higher prices as well as to add diversification to a portfolio anchored in stocks and bonds. Several posters noted that they agreed with market guru Jeremy Grantham, who in a recent commentary argued that the world has entered a period in which constrained natural resources and rising prices will be the norm.

Most posters cited a position size of 5%-10% for commodities exposure, though some posters indicated they'd staked as much as 20% in the asset class.  PIMCO Commodity Real Return Strategy  (PCRAX) and no-load near-clone  Harbor Commodity Real Return   received frequent mentions as go-to investments for long-term commodities investors. Exchange-traded funds and notes such as  PowerShares DB Commodity Index Tracking (DBC) and  iPath DJ-UBS Commodity Index (DJP), as well as  SPDR Gold Shares (GLD), also received multiple shout-outs, though some users noted they're uncomfortable with the credit risk that exchange-traded notes court.

KYRich offered one of the most detailed rationales for taking a long-term position in a broad-basket commodities investment, noting that Ibbotson research had prompted his embrace of the asset class. "For my portfolio, I include commodities as part of a super asset class (I'll refer to it as 'real return hard' assets) along with the traditional cash, bonds, and equities. This class includes everything (Treasury Inflation-Protected Securities, real estate, and so on) that has a high correlation to inflation. My target for this basket is 15%, +/- 2%. In my opinion, the best vehicle for broad commodity exposure is to invest in the funds that are known as 'collateralized total return commodity index.' I am personally invested in the PIMCO Commodity Real Return. These funds are collateralized (essentially invest in an underlying bond portfolio, often heavily weighted in TIPS) to cover their commodity trades. I like this approach because the TIPS give you a double benefit of high correlation to inflation.

"The other vehicle that I use is a little-known exchange-traded fund,  Greenhaven Continuous Commodity . It essentially does the same as the above-mentioned mutual fund. It uses a different index (Continuous Commodity Total Return Index), which is an equal weighting of 17 different commodities."

Poster Uysses has a similar mindset, noting "I decided a couple of years ago to allocate between 3% and 7% in commodities-related assets. I view this as part of my nonequity allocation, as an inflation hedge that complements my holdings in individual TIPS (which are about 12% of my total assets). Currently I have about 4%-5% of my total portfolio split between Harbor Commodity Real Return and SPDR Gold Shares."

Feelnopain has taken a slightly larger position in commodities, noting, "I have a long-term allocation of 10% in commodities (7% in PowerShares DB Commodity Index Tracking and 3% in  iShares Gold Trust (IAU), rebalanced quarterly) in an effort to reduce overall volatility in my portfolio.

"I keep my entire commodity position in tax-sheltered accounts to avoid accounting problems. I agree with other posters about avoiding ETNs because of the risk you're taking on the issuing firm. I do not make 'tactical' trades as I think it is a sucker's game for the individual investor. I am sticking with my fixed-allocation approach despite today's commodity crash."

Not Buying it
Meanwhile, a large contingent of users is content to watch commodities' gyrations from the sidelines. Many cited valuation considerations, along with the vagaries of the commodities market, as key factors behind the decision to stay away.

FidlStix wrote, "I have avoided them. Aside from their huge volatility, I've skipped commodities because they're a different breed of cat. I don't presently feel competent to invest in them. Right now I would probably do (almost) as well in Las Vegas as I would investing in commodities. However in five years . . . ? My portfolio might even look somewhat commodity-centric by then. I think their potential as investments are huge, if you know what you're doing."

Poster cgajowski hinted at valuation considerations with this post: "I've been on the end of the diving board but never jumped in the pool. I believe that commodities are bound to go up long term and that some part of my portfolio should have exposure. But I have indecision as to which fund/exchange-traded to use. And 'derivative' commodities or real ones? Currently feel that--if I can decide--there will probably be a better time to buy after some pullbacks."

Darwinian was more clear-cut in his views about the asset class. "How quickly we forget! This is exactly what everyone was saying in the 1970s, the last time there was a commodity bubble. Remember what happened for the next 20 years? For those who are entranced by the 'diversification' benefits of commodities, please allow me to translate this into plain English. When your equity investments are soaring sky-high, racking up big profits--as they tend to do, most of the time--your commodities are going to be sitting there like dead skunks, going nowhere, stinking up your portfolio and costing you money. In the long run, commodities barely keep pace with inflation. This was demonstrated by a famous bet, in which environmentalist Paul Ehrlich, who was sold on the tall tale that commodities would be the world's 'Limits to Growth,' wagered against libertarian Julian Simon that a selection of five commodities, picked by Erhlich, would rise in price during the next 10 years. All five went down." (Note to Darwinian: Next time, tell us what you really think.)

NYCKid was similarly equivocal about the decision to avoid commodities. "I have respect for Grantham, and I read with great interest his quarterly reports and other articles. But his long-term thesis on commodities strikes me as a bet against human ingenuity. If he's right about the future course of commodity prices, the incentives to engineer around the problem will increase, and that's a force I'm not prepared to bet against. I admit that there's also an emotional component to my position: I don't really want to bet that we can't solve these problems. I also do not invest in commodities for the other reasons that some people do: general inflation hedging and portfolio diversification.

"As I understand the state of the research, the notion that commodities deliver these benefits is pretty controversial, and Eugene Fama and Kenneth French persuasively argue that any such theoretical benefits are swamped by the volatility of commodities. And, while you will always hear stories about some people who guessed right with respect to an asset class, remember that commodity speculation is a dicey game, in part because prices are subject to market manipulation (by big players) that dislodges the relationship between price and supply/demand.

"Finally, Jack Bogle says stay away. Bill Bernstein says stay away. Fama and French say stay away. David Swensen says individual investors should stay away. Gosh, I'm going to stay away. (Note that Burton Malkiel has recommended exposure to companies that mine and manufacture commodities and to countries whose economies are geared toward the production of commodities. I think some of that, at least, can be done through an emerging-markets fund.)"

Commodities Through the Back Door
Much as Malkiel advises, some posters believe that buying the equities of commodity-producing companies provides a healthy way to split the difference. In so doing, they can gain some exposure to commodity-price movements without venturing into a commodity-tracking investment straight up. In contrast with investments that attempt to track commodity prices via futures, stocks of commodity-producing companies don't reflect commodity prices directly, but the stocks are often beneficiaries when commodity prices are heading up.

FelixKrull summed up the case for owning the equities of commodities producers with this posting: "I think what most investors fail to realize is that commodities and stocks are quite correlated. You needn't own the commodities ETFs or mutual funds in order to profit from them. That is why I own individual stocks, some of which are strongly linked to commodities-- Southern Copper (SCCO), Corn Products International (CPO), and  ConocoPhillips (COP), for example. Because I am a dividend investor, I believe it is important for every security I own to pay me a return. If commodity prices soar, then the companies I own will do well and likely increase their dividends, and I will profit from them."

DaveD82 shared a similar mindset as well as some of his favorite commodity-related names. "I would personally rather own an actual business than a derivative of a commodity, but I am familiar with the research and diversification benefits supporting the latter. Putting that aside, I do believe that through careful analysis and discipline, one could find a few gems in this otherwise fairly valued sector of the market. In reference to the GMO article, I'll use a similar stratification of the commodities and focus my efforts onto oil/gas, metals, and agricultural commodities. Without divulging all the details, I think investors should pay particularly close attention to  ExxonMobil (XOM),  Rio Tinto (RIO), and Yara International (YARIY).

Other posters noted that they've taken a similar tack but have used funds rather than stocks.  T. Rowe Price New Era (PRNEX) received multiple mentions as a favorite among those seeking commodities exposure via equities. MartyFL wrote, "I added T. Rowe Price New Era to my portfolio to add some commodity exposure. I am not a fan of buying the actual commodities or ETNs because of a variety of drawbacks: no dividends, cost of rolling the futures, tax implications, and so on. Therefore, I went with the New Era fund, which holds stocks of many of the suppliers of the commodities. I hope if there is a downturn or crash, those stocks will not significantly underperform the underlying commodities."

Ekimw1947 is on a similar wavelength, albeit with a different fund. "I decided to put my foot in the water about 45 days ago, after becoming interested in October 2010, when I purchased Market Vectors RVE Hard Assets Producers (HAP). I looked at both the Market Vectors fund and  Fidelity Global Commodity Stock (FFGCX) because I didn't feel comfortable with just the commodity itself. Both funds invest in the producers that tie to the individual commodity or better said, '...in equity securities, which may include depositary receipts, of U.S. and foreign hard-asset producer companies.' This way I felt I could soften some of the volatility associated with commodities with the equity security of the companies that produce the commodity and make 'stuff.'"

Poster dawgie has also eschewed commodity futures funds, instead seeking inflation protection with a broad basket of investments. He wrote, "I have about 12.5% of my IRA invested in what I call inflation fighters: commodity stocks, floating bank loans, and REITs. The funds I am using are  Fidelity Select Natural Resources (FNARX), Fidelity Global Commodity Stock,  Fidelity Floating Rate High Income (FFRHX), and  Fidelity Real Estate Investment (FRESX), since my IRA is with Fidelity. I have purposely steered away from TIPS funds because their yields are so low that I think they do not offer enough value. Plus, they would likely get hammered if interest rates rise. Likewise, I have steered away from commodity futures funds because I once owned the  PIMCO Commodity Real Return Strategy  for several years and did not like the way it performed. It lost just as much as commodity-stock funds on bad market days, but never gained as much on the good days. Over time, its returns were about half as much as comparable commodity-stock funds.

"In my view, commodity-stock funds that invest heavily in energy are a good bet because there is only so much oil and other natural resources and world demand is unlikely to decline unless we have some sort of global epidemic that kills billions of people. There is only so much petroleum and other resources."

Sensei made the astute observation that you don't need to invest in a natural-resources fund to obtain commodities exposure. "While I believe that commodities are a valuable component of a well-diversified portfolio, I'm not convinced at this time of a need to purchase a dedicated commodities fund. I own three allocation funds,  IVA Worldwide ,  PIMCO All Asset All Authority , and  FPA Crescent (FPACX), which can invest in them to varying degrees. Commodities are quite volatile, and I would prefer to let these experienced fund managers make the call."

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