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Are Commodities the “Next Best Thing?

With the U.S. stock market’s dismal performance during the “lost decade,” return-chasing investors looking for the next best thing may think they have found it in commodities. This asset class returned around six percent annually during the past 10 years.

Usually “the next best thing” soon takes its turn becoming “the last worst thing.” Still, commodities are one of the ten asset classes I recommend all long-term investors consider for their portfolios.

Even though commodities are tangible assets like corn, coffee, or oil, you don’t invest in them by renting a warehouse and filling it with truckloads, bags, and barrels. When investment advisors refer to investing in commodities, they are actually referring to investing in commodities futures.

Don’t let the term “futures” scare you. I’m not suggesting you consider playing the futures market, risking the loss of much more than your investment by using extreme leverage. I recommend a non-leveraged investment in commodity futures.

Commodity futures are a short-term claim on a commodity. Commodity futures do not raise capital, the way stocks do, but rather allow sellers to obtain insurance to lock in prices for the future delivery of their commodities.

Commodity futures, then, do not represent direct purchases of the commodities (the spot price), but bets on the expected future selling price of a commodity. A commodity futures contract is an agreement to buy or sell a specified quantity of a commodity on a future date at an agreed-upon price. The investor (sometimes inappropriately called an “evil speculator” by cable news commentators) provides the seller of the commodities a guaranteed price or “insurance” by assuming the risk of unexpected movements in the future spot price.

Most investors in commodities will diversify by buying a basket of various commodities, called an index. There are several commodity indexes like the GSCI and the DJ-UBS. Since commodities pay no dividends, the only way to make money from commodities is if they appreciate in value.

There are large differences in the historical performance of spot commodity prices and commodity futures. Buying an index of “spot” commodities in 1959 and holding it for 45 years produced a total return of 3.47%, lower than the average inflation rate of 4.15%. This is consistent with the common wisdom that over the long term commodity prices haven’t kept pace with inflation.

Instead, had an investor purchased an index of commodity futures in 1959 and annually rebalanced the index to equal weights, the return would have been 11.18%. This was comparable to the return of the S&P 500. However, the commodity futures had about 20% less volatility than the S&P 500.

If the return of commodity futures equals that of stocks, why bother to have both? The reason is the two asset classes tend to move contrary to one another, which lowers the volatility of the overall portfolio and increases the return.

The most effective way to incorporate commodities into your portfolio is by investing in a commodity mutual fund; PCRAX is one example. There are also a number of exchange traded funds. Be sure to do a little homework on the fund’s strategies, as each one can employ a different technique.

Finally, be sure that your investment in commodities is for the long term. Trying to time the commodities market or a specific commodity isn’t advisable. Pick your allocation, say five to 15 percent of your portfolio, and stick with it, rebalancing at least annually.

Peaks and valleys are an inherent part of any investment in equities. If history is any indication, adding a sliver of commodities to your portfolio will help smooth out your investment landscape.

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