How to Invest in Commodities

Commodities can add diversification to a traditional portfolio.

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Commodities remain an extremely volatile investment, but many advisers recommend that investors consider using commodities in a small part of their portfolio for purposes of diversification. The term is used for products that range from natural gas to pork bellies. "Five years ago, they were more of a novelty," says Tom Lydon, editor of ETFTrends.com. "Now, with the potential of inflation and the greater demand for commodities around the world, there's definitely a reason to have between 5 and 10 percent of your overall allocation in commodities." Here's a few things to consider before investing: 

Understand the risks. For some investors who are willing to think outside the box, investing in commodities can actually bring down the overall volatility of their portfolio. Investing in commodities alone is an extremely volatile endeavour, and investors should be aware of this before they consider investing. "There's of course going to be times when commodities don't do well," says Tom Idzorek, chief investment officer at Ibbotson Associates, a Morningstar company. "If people are scared off by that, then chances are commodities aren't for them."

The benefit for investors is that commodities aren't correlated with more traditional investments like stocks and bonds. Commodities tend to perform well when other asset classes, like stocks, are struggling. Because of that, investments in commodities can lower your portfolio's overall volatility. "While stocks are zigging, commodities are zagging," says Jerry Miccolis, principal and CIO with Brinton Eaton, a Madison, N.J.-based wealth management firm. "When you combine them together with stocks, you have a portfolio that has less zigs and zags than you would have if you had either one individually." 

Diversify. Don't put all of your eggs in one basket. There have been a number of new funds launched that track a single commodity. Many of these funds have done quite well, but there's no telling how long their success will last. Investors shouldn't get caught up chasing the hottest new commodity. Gold, for instance, has been one of the most popular commodities of late, but Lydon warns that the price may not appreciate much longer. That's why many advisers suggest diversifying and investing in a broad basket of commodities. "For most investors, they shouldn't be buying these very specific products," Idzorek says. "Most investors should be getting broad exposure to a large number of commodities." 

Pick your funds. For broad exposure to commodities, advisers suggest investing in a number of mutual funds and exchange-traded funds that track a range of commodities, including metals like gold and silver, natural gas and oil, livestock, and agricultural products like soybeans. Investors also can get exposure to commodities through investing in the stocks of companies that produce commodities, but advisers say many investors probably already have exposure to some of these types of companies through more traditional means like a broad stock fund. Miccolis says that his firm has used mutual funds like Oppenheimer Commodity Strategy Total Return Fund (symbol QRAAX) and PIMCO Commodity Real Return Strategy Fund (PCRAX) in the past. Both funds invest in instruments that provide broad commodities exposure. Lydon recommends ETFs like PowerShares DB Commodity Index Tracking Fund (DBC), which tracks an index with a wide range of different commodities.