Will Commodities Wreck Your Portfolio?

Commodities investing has been the subject of much debate. BusinessWeek's article "Amber Waves of Pain" added fuel to the fire, describing all the pain investors in funds that invested in commodities futures had experienced. This week, we'll take a closer look at investing in commodities, starting with how commodities investing works.

The BusinessWeek article discussed how academic research, such as Gary Gorton and K. Geert Rouwenhorst's June 2004 paper, "Facts and Fantasies About Commodities," led to a dramatic increase (hundreds of billions) in the flow of investments into commodity funds -- and how that increase had permanently changed the landscape by increasing the cost of rolling futures contracts. Let me explain.

Commodity funds don't invest in actual, physical commodities, but in commodities futures instead. For example, a fund might buy a contract in August for delivery in September. Fund managers don't actually want to take possession of, say, oil, so they'll roll over the fund's position prior to maturity, selling the September contract and buying another contract whose maturity is further into the future. There are two terms used when comparing the price of a future delivery (like the example described above) to the current price:

• When the future price is higher than the current price, it's called contango. (Technically, it's called trader's contango.)
• When it's lower, it's called backwardation (or trader's backwardation).

However, simply avoiding commodities because of their recent performance isn't a good idea. As we've discussed before, looking at investments in isolation is the wrong way to determine if they're appropriate for your portfolio. This week, we'll see how the addition of commodities has affected portfolios, look a little deeper at the BusinessWeek article and address some of the points raised.