Diversification is one of the most important rules of investing. If you invest in a range of different asset classes, such as stocks and bonds, losses in one may be offset by gains in another. Investing in commodities—whether it's oil, gold, or pork bellies—is yet another way to achieve broader diversification.
"We believe they have a role in just about every client's portfolio—aggressive, conservative, or anything in between," says Jerry Miccolis, coauthor of Asset Allocation For Dummies and principal and chief investment officer of wealth management firm Brinton Eaton. "The reason is that they typically zig when the more traditional investments zag."
Many advisers recommend commodities funds to their clients, in part because it's easier than ever to invest in commodities. The emergence of investing options like exchange-traded funds has made what was once an exotic asset class more accessible. "Commodities are now more broadly recognized as an asset class that investors and advisers have access to, and everybody is trying to figure out how much they should allocate to them in their portfolio and in what form," says Tom Lydon, editor of ETFTrends.com.
For many investment advisers, the case for commodities goes further than diversification. Commodities are commonly used as a hedge against inflation, which some experts say could become an issue over the long term. Rapidly growing emerging economies including China and India will increase demand for commodities as well. Some advisers recommend a portfolio allocation of between 5 and 10 percent to commodities, depending on clients' investing time horizon and risk tolerance. It's important to be cautious, though, as commodities can be an extremely volatile asset class.
U.S. News spoke with a few investment experts about how to incorporate different commodities into a portfolio in today's market:
Gold. In recent weeks, gold has soared to historic highs of more than $1,250 per ounce. Historically, the precious metal has benefited from volatility in the stock market, as investors get spooked and seek safety. SPDR Gold Shares ETF (ticker GLD), which holds actual gold bullion in underground vaults and tracks the spot price, has seen its net assets skyrocket to more than $50 billion since its 2004 inception—making it the second-largest ETF behind SPDR S&P 500 ETF (SPY). Depending on who you ask, gold could be poised for an even bigger run-up, or just the opposite. "If we saw $1,400 gold by Christmas, that wouldn't surprise me," says Sean Brodrick, small cap and natural resources analyst for the blog Uncommon Wisdom Daily. Brodrick believes gold could reach $1,600 an ounce sometime in 2012. Others aren't so sure.
Lydon points to a different route to access the yellow metal: stocks of gold mining companies. "Even if gold stays flat from this point going forward, these companies are going to continue to be very, very profitable," Lydon says. "If you've missed the gold trend at this point, consider the metals miners." Lydon recommends Market Vectors Gold Miners ETF (GDX), which holds gold mining companies throughout the world.
Silver. Often referred to as the "poor man's gold" because it generally trades at a lower price, silver has been on its own rally of late. The metal recently closed at more than $20 per ounce, a level not seen since March 2008. iShares Silver Trust ETF (SLV), which holds physical silver bullion and tracks the spot price, has outperformed its yellow counterpart, SPDR Gold Shares, so far in 2010. Year-to-date, the funds have returned 17 percent and 13 percent, respectively. Experts say silver has benefited from more than just uncertainty in the market. "It plays both sides of the fence," Lydon says. "It's not only a precious metal that's used in jewelry—and that has the same types of demand [as gold]—it's also used as an industrial metal." As the global economy recovers, Brodrick believes there may still be some upside for silver because it's used in a range of products, including LCD TVs and microprocessors.
Platinum and palladium. Platinum is similar to silver in that it's considered both a precious and industrial metal that's found in a number of different products. It will generally trade at a fairly high price, says Lydon, because it has a rather strained production line. Currently, platinum is trading around $1,500 per ounce. Platinum and palladium are used extensively in the production of cars, primarily for catalytic converters, so their performance is fairly dependent on global car production and sales. While car sales in the United States have been lackluster, China saw sales of 1.2 million in August—up 56 percent from the previous month. That large of a number may not be sustainable, Brodrick says, but over time the growing Chinese middle class will begin to demand more luxuries like cars. And that bodes well for platinum and palladium. ETFS Physical Palladium (PALL) and ETFS Physical Platinum (PPLT) both hold the physical metals and track the spot price. Both funds were launched by ETF Securities earlier this year. Brodrick cautions that the funds trade at very light volumes and can be extremely volatile at times.
Oil and natural gas. Lately, oil prices have been somewhat depressed because of a lack of demand during the global economic slowdown and a surplus of supply. "We're seeing this trading range between mid-$60s and $80 a barrel for oil, and we're probably going to continue to operate there for a while until the economies begin to look better," Lydon says. Investors can get access to spot oil prices through futures contracts with funds like United States Oil ETF (USO), but with prices trading in such a low range, Brodrick suggests that they consider alternatives. "There are investments you can make that pay you big, fat dividends, and I'm talking about pipeline companies and even some of the oil producers," he says. Oil pipeline company Buckeye Partners (BPL) and ConocoPhillips (COP) are two of his favorites. Buckeye Partners is currently yielding 6 percent, while ConocoPhillips offers a dividend of 4 percent. El Paso Pipeline Partners (EPB) is a natural gas play for investors that also offers a sizable 5 percent dividend.
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Agricultural products. Generally, commodities tend to be cyclical in nature. Christian Hviid, director of market strategy at Genworth Financial Asset Management, says his firm is expecting extremely slow growth in the United States going forward, and that means he's staying away from many of the more cyclical commodities like those in the energy sector. "Longer-term, we like commodities, but because of some of the cyclical forces, one needs to tread carefully around certain types of commodity exposures that are out there," he says. He currently favors agriculture. Hviid says products like grains and livestock generally have more constant demand. "Those areas tend to move less in terms of association of what the economy is doing because there is always demand for food," he says. Demand from emerging markets will drive commodity production in the future. The population in these countries is growing steadily, and as a larger middle class emerges in places like China, people there will begin to consume higher-calorie foods, Hviid says. Lydon recommends two ETFs for investors looking to invest in agriculture: PowerShares DB Agriculture (DBA) and Market Vectors Global Agribusiness (MOO). Both hold futures contracts for a variety of agricultural products.
A little bit of everything. For many investors, checking the price of any single commodity on a consistent basis may be too complicated. ETFs have made investing in a single commodity easy, but they also offer investors the option to invest in a number of commodities within a single fund. Some advisers suggest a more diversified approach. "Our preference is to do it through a broad-based basket of commodities—not to try to pick and choose commodities," Miccolis says. Experts say this strategy can be a useful for investors who are wading into the sector for the first time. Miccolis says he has used a combination of mutual funds and ETFs in the past for his clients including Oppenheimer Commodity Strategy Total Return (QRAAX) and PIMCO Commodity Real Return Strategy. Lydon recommends iShares S&P GSCI Commodity-Indexed Trust ETF (GSG) or PowerShares DB Commodity Index Tracking ETF (DBC).