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Gold, Oil, and More: 5 Rules for Investing in Commodities

There are lots of good reasons to invest a portion of your portfolio in commodities, but the most profound may be very simple: We are running out of stuff. We have to dig deeper to find oil, mine more dirt to find copper, knock down more mountains to find anthracite. For a long-term investor, it's tough to do better than own necessities that are growing scarcer.

You’ve heard about the importance of diversifying (ad nauseam), and commodities will also help diversify your portfolio. As MoneyWatch’s Larry Swedroe has shown, commodities historically have shown a very low correlation to equities and can lower your portfolio’s volatility. Agriculture goods, livestock, metals, oil, and gas are the foundation of the global economy and their prices typically move in different directions than stocks and bonds. Natural resources also offer a hedge against a falling dollar, since they tend to get more expensive as the greenback loses value. “Commodities will do wonderful things” to round out a portfolio, says Roger Gibson, chief investment officer of Gibson Capital Management and author of Asset Allocation.

But at the end of the day (or at least the fiscal year) you want to make money, and investing in commodities could boost your returns. This appears to be a propitious time to get in. The recent massive global economic collapse resulted in a crash in commodity prices, but the world will be growing again. Already, industrial production and retail sales — key gauges for commodities demand — have started rising. And commodity prices, which move early during economic rebounds, have headed up. Copper, for example, has doubled in price in 2009.

The most compelling argument for commodities may be the long-term outlook. Jeremy Grantham, chairman of the GMO investment management firm, says that although commodity supply has outstripped demand historically, we’ve seen the peak and demand will now be ascendant. “We must prepare ourselves for waves of higher resource prices and periods of shortages unlike anything we have faced outside of wartime conditions,” he wrote recently. And you needn’t become an expert in pork bellies or tin to invest. Commodity mutual funds and exchange traded funds (ETFs) can give you broad exposure to a wide range of natural resources. Many financial advisers recommend keeping about 5 percent of your portfolio in commodities. These five rules will show you how to invest wisely and minimize risks:

1. Prepare for Rocky Returns

Just because commodities reduce a portfolio’s long-term volatility doesn’t mean your commodity fund will glide calmly higher. Commodity prices can fluctuate dramatically due to everything from bad weather to war to fickle consumers. The DJ-UBS Commodity Index is up 9.0 percent in 2009 through September, but commodities nosedived along with stocks in 2008.

Last year’s conjoined returns were atypical, though. (All risk assets took a swan dive last year, making it an unusually painful year by historical standards.) In the bear market of 2000-02, when U.S. stocks shed nearly half their value, commodities advanced roughly 34 percent, according to data from Morningstar Principia.

2. Buy Funds or ETFs

The cheapest way to invest in commodities is through a mutual fund or ETF that buys an assortment of natural resources futures contracts or holds stocks of companies that make or process the raw materials. Steer clear of increasingly popular exchange traded notes (ETNs), a quirky cousin to ETFs. ETNs are a form of debt; they’re essentially bonds promising to make payments mirroring their underlying index. So buying them means you’re counting on not only the commodity’s performance, but also the credit quality of the ETN issuer. That’s more risk than necessary.

3. Stay Broad

Don’t try making a bet on the outlook for a particular commodity, such as oil, wheat, or copper, with a mutual fund or ETF that owns just one type of resource. It’s a loser’s game. Instead, stick with a diversified low-cost index fund or ETF. has complete lists, with information about their fees, holdings, management, and performance.

4. Choose a Fund with the Right Index

You may be surprised how much the yardstick matters when choosing a commodity index fund. The most popular commodity indices, Dow Jones-UBS index (DJ-UBS) and S&P Goldman Sachs Commodity Index (GSCI), define and weight commodities vastly differently. The result: substantially different risk and return profiles for the index funds using them.

The GSCI is weighted 65 percent in energy (crude oil, natural gas, gasoline), the most volatile commodity category. DJ-UBS has an energy weighting of just 33 percent. Consequently, the iShares S&P GSCI Commodity-Indexed Trust ETF (GSG) posted an annualized loss of 11 percent for the three years through September 2009 — more than twice as steep as the retreat for Credit Suisse Commodity Return Strategy A (CRSOX), a mutual fund tracking DJ-UBS. You’re better off with a fund tracking the DJ-UBS index (no ETFs do), especially because there’s a good chance you already own mutual funds with energy-related exposure through stocks such as Exxon. Your funds are less likely to own wheat futures.

The Credit Suisse fund is the low-cost leader among DJ-UBS-index commodity funds. Another worthy choice is Pimco Real Return Strategy D (PCRDX), the largest commodity fund, although its 1.24 percent expense ratio is higher than Credit Suisse’s 0.70 percent.

5. Consider a Fund That Buys Stocks of Commodity Businesses

If you’re uncomfortable owning commodities directly, buy a low-cost fund or ETF holding stock in companies that produce and market natural resources. These firms aim to protect investors against commodity market collapses, through hedging and, sometimes, by paying dividends. Funds and ETFs that own those stocks aren’t perfect surrogates for ones that buy commodities contracts, though. After all, their performance is based partly on the management of the businesses, and their shares can move based on stock market forces unrelated to the commodity markets. Just because the price of crude oil is rising doesn’t mean an oil company can’t lose money or that its stock will head north. And remember, if you own a Standard & Poor’s 500 index fund or ETF, you already own stock in these companies. Roughly 15 percent of the S&P 500 is in commodity companies.

With those caveats, T. Rowe Price New Era (PRNEX) is a 41-year-old, low-cost natural resources equity fund that holds 85 to 100 domestic and international stocks. And a new ETF, Thomson Reuters/Jefferies CRB Commodity Equity Index Fund (CRBQ), similarly tracks an index of 147 stocks.

James Picerno is editor of the Beta Investment Report.

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