If you watch TV, read the newspaper, or listen to the radio, you have probably heard something about buying gold. With gold prices hovering near all time nominal highs, investors may be tempted to participate in the rally. Simply buying gold, however, does not constitute a well diversified approach to investing in hard assets. Commodities are a distinct asset class that can reward prudent investors with significant diversification benefits, but only if exposure is properly managed.
So what is a commodity? A commodity is any physical substance that has value and can be easily stored and traded. A commodity can be anything from a herd of cattle to a high grade diamond, but it is commodities that trade in large volumes that are the basis of primary commodities exchanges throughout the world, of which the Chicago Mercantile Exchange is a prime example. The importance of some of these commodities can be quite surprising. For example, the dollar volume of coffee trading far exceeds gold trading and, next to oil, is the most valuable global commodity.
Typically, many investors have investment portfolios that are comprised of three main asset classes: stocks, bonds and cash. Adding commodities to this mix can improve returns on a risk adjusted basis because commodities have demonstrated a negative correlation with stocks and bonds over long periods of time1. A negative correlation between asset classes means that prices tend to move in opposite directions. Research indicates that commodities can offer returns that are similar to stocks, but have the ability to “zig” when stocks and bonds “zag.” This means that commodities can reduce the severity of business cycle declines in your overall portfolio.
The main reason that commodities behave differently than either stocks or bonds over the course of a business cycle is the fact that commodities respond favorably to increases in inflation — especially inflation in raw materials caused by industrial demand in developing regions. Inflation, by definition, means rising prices for goods and services. So, while these rising prices often present headwinds for stock and bond investors, investors with well diversified positions in commodities will benefit.
But how should you invest in commodities? While buying shares of companies that produce or refine commodities can be profitable, these securities are ultimately still stocks and do not provide the same kind of correlation benefits as direct exposure to the underlying hard assets. On the other hand, although it is possible to buy and store physical commodities, this is often too expensive and cumbersome to be effective. A much better way to obtain exposure to commodities is through futures contracts. For our purposes, it suffices to say that futures contracts are securities that trade on exchanges and are based on prices for the future delivery of different commodities. These contracts can be used by suppliers such as farmers or mining firms to insure the future value of their products, by purchasers such as airlines and manufacturers to insure against price hikes for products that they will need to buy in the future, and by traders who simply want to bet or “hedge” against future price movements.
Before investing in commodities, it is important to understand that alone, the asset class is fairly risky. Commodities prices are very sensitive to supply and demand inputs that can result from weather changes, new production, political events, herd psychology and large volume trades. Aside from the overall diversification benefits to a stock and bond portfolio, you should expect volatility in the commodities markets alone to be no less, and possibly greater, than that of the stock market.
If you have determined that an allocation to commodities futures is consistent with your risk tolerance and investment objectives, how do you add that exposure to your portfolio? Many people typically think of gold and oil when considering commodities. Gold and oil, however, do not provide any exposure to industrial metals, industrial materials, agricultural commodities and livestock. These important parts of the commodities markets are often overlooked, but they can be the best performing parts of the market. Sugar, cotton and copper, for example, have been some of the best performing commodities over the past year and have greatly outperformed both gold and oil. It cannot be stressed enough that diversification within the commodities markets is just as important as diversification in the stock and bond markets.
One of the easiest and lowest cost ways that you can obtain well diversified exposure to commodities is through a fund that tracks a commodities index. There are a few different commodities indexes that are widely followed, and you may want to review your objectives with a financial planner to determine which index is right for you.
1 Gorton, Gary B, and K. Geert Rouwenhorst, “Facts and Fantasies about Commodity Futures,” Yale International Center for Finance, Yale ICF Working Paper No. 04-20, June 14, 2004
FPA member David Zuckerman, CFP®, CIMA®, is Principal and Chief Investment Officer at Zuckerman Capital Management, LLC in Los Angeles, CA. He serves as Director of Public Relations for the Los Angeles chapter of the Financial Planning Association.