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Submitted by: Bill Cleveland
The author is a fee-only certified financial planner (CFP®) with Preston & Cleveland Wealth Management, LLC in Augusta and Atlanta, GA. He is a member of the National Association of Personal Financial Advisors (NAPFA) and provides comprehensive financial planning and investment management services to high net worth individuals and retirement plans across the country. Bill was recently selected as one of The 150 Best Financial Advisers for Doctors in the country by Medical Economics magazine.
As of April 1, 2008
If you've heard the term commodities for years but never truly understood what this asset class is or why you'd invest in it, I hope this article will give you a better understanding.
Commodities are tangible goods—like oil, gold, corn, or cattle—that are bought and sold by professional traders on specialized exchanges. Large organizations such as mutual funds and insurance companies have been investing in commodities for years. But there hasn't been a low-cost, tax-efficient manner for individual investors to join in until recently.
Why are commodities so hot now? The biggest reason is that growing nations are clamoring for more raw materials. Here in the US, for example, increasing demand for ethanol has led to higher corn prices. The supply of oil has not kept pace with increasing global demand causing prices to significantly increase. China and other burgeoning Asian countries' appetite for cars, homes, and other items has increased, resulting in a greater need for building materials and metals.
Because the return on these goods doesn't follow the ups and downs of stocks or bonds, including them in your portfolio can reduce overall risk if you’re a long-term investor. The total return of the Dow Jones-AIG Commodity Index (DJ-AIGCI), one of the most frequently used commodity benchmarks, has a historically very low correlation with the S&P 500 Index, and even less with the Lehman Brothers US Aggregate Index, which tracks a broad range of bonds. A low correlation means that commodities typically move independently of stocks and bonds, sometimes in the same direction, but many times in the opposite direction. In addition, if inflation edges higher, commodity returns tend to go higher too. On the other hand, stocks and bonds tend to falter during periods of high inflation.
That's not to say commodities are a sure thing: In 1998, the DJ-AIGCI lost 27 percent, while the S&P 500 gained 29 percent. Volatility is high because prices are impacted by many different factors, including weather, disease, regulatory developments, trade embargoes, disputes, as well as tariffs.
Political instability is another risk because a large portion of the world's commodity producers are located in volatile countries such as Venezuela, Russia, and China. Since commodities have been on a roll for several years, some experts are predicting a slowdown. As of March 24, the Goldman Sachs Commodity Index increased close to 40% in the past seven months. While recent performance demonstrates the benefits this asset class has to a portfolio (while stocks have been going down), it also reminds us of the significant volatility that you can expect from investing in commodity-related funds. Over a short term time period, these gains could easily reverse.
In a recent article in Barrons titled “Time to Leave the Party,” the author noted that close to $30 billion in fresh investments have entered commodity-related funds since the start of this year. Macquarie Bank notes that this increases the total investment in commodities by speculators to as much as $172 billion. Given investors’ dismal record of being able to time the market, mutual fund inflows and outflows are often contrarian indicators of which way the market is heading. For example, over the past decade the month with the largest net inflow of assets into mutual funds occurred in February 2000, just before one of the worst three-year periods in the market. The biggest outflows occurred in the months leading up to October 2002, just when the market hit bottom.
Before adding specific commodity funds to your portfolio, check to see how much exposure you already have to commodity- and oil-related funds. Just by owning a large cap stock fund like the Fidelity 500 Index fund, you would have about 13% exposure to energy-related stocks with Exxon, Chevron, and ConocoPhillips being some of the top holdings.
The bottom line is that an allocation to commodities can reduce the overall risk of a portfolio over the long-term, given its low correlation to stocks and bonds. However, over the short term given the amount of speculation in the asset class and the recent significant gains in commodities from oil, to corn, to gold, the risk/reward tradeoff is not as attractive as it once was. As with any investing decision, make sure you are investing in the asset class only after you have done your homework and that you are investing in it for the right reasons.
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