Commodities haven’t just had a rough year. It’s been more like a rough half-decade, in which prices of raw materials and foodstuffs were halved. Once a mainstay ingredient in the investing soup, this asset class is now being shunned, and some people are making ever more bearish price forecasts.
So is it time to jump back in and gain the well-documented investing benefits of adding metals, grains and energy into your investment pot? Maybe so, and there are good reasons to consider it (plus some pitfalls to avoid).
First, there is the broad reason to own commodities, which is to reduce risk. Because the prices of commodities tend to be uncorrelated with the prices of other assets such as stocks and bonds, the overall volatility of a portfolio tends to be lower. And because most investors define risk as volatility, when it is lower there is less risk.
“You have a smoother ride [in your portfolio],” says veteran commodity trader Victor Sperandeo, CEO of Dallas-based investment management company EAM Partners LP and author of “Trader Vic on Commodities.”
Sperandeo normally recommends commodities as 5 percent to 10 percent of a portfolio, and to maintain a position even when prices are dropping. “That’s OK, because you would have made a lot more money on the stocks and bonds that you owned,” he says.
He’s correct on all fronts there. And because commodities have declined a lot, Sperandeo now recommends an allocation of 15 percent to 20 percent. “You want to buy low and sell high,” he says.
And low is where we are now in the commodity complex, at least compared to a few years ago. The Dow Jones commodity index, which is weighted in equal thirds to energy, agriculture and livestock, and metals, reached a post-recession high of 515 in April 2011 and has declined close to 50 percent. The index gets rebalanced quarterly.
How to buy commodities.
Investors who are underweight in commodities should start topping it up slowly. But even those without a position in commodities should act without haste. Sperandeo suggests adding a sixth of the target position each month. Experienced investors call this dollar-cost averaging, and while you might not hit the bottom of the market, you are less likely to get the worst prices.
In the current scenario, there appears to be plenty of upside and limited downside, Sperandeo says. “They [commodities prices] could go down another 10 percent, but up another 100 percent.”
So how do you do this? One thing worth noting is that you should not go to the Chicago Mercantile Exchange and start trading futures contracts, unless you are a professional trader. Doing so is a way to lose lots of money very quickly. That’s because futures contracts are typically traded with lots of so-called margin, or borrowing. In simple terms, it means gains and losses are magnified.
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says Terry Gardner Jr., senior managing director at registered investment adviser C.J. Lawrence in New York. “You have to know when to get in and when to get out.” That’s in part because futures have a finite life, whereas stocks can theoretically live forever.
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Stocks that benefit from improving commodities.
One group to consider are mining companies such as Freeport McMoRan (ticker: FCX) which mines metals and has an energy business, BHP Billiton Limited (BHP) an industrial minerals miner, and Monsanto Co. (MON), which sells agricultural chemicals.
Gardner points out there are risks other than changes in the price of commodities when investing in stocks. Sometimes the management of a firm makes poor decisions, for instance. Such decisions have at times been industry-wide and have included massive overspending on new projects, to the detriment of shareholders.
Tim Rudderow, president and CIO of asset management firm Mount Lucas Management, says this downdraft in commodity prices has created some bargains where stocks have been unfairly marked down. “The move down has created great opportunities for refiners,” he says.
Oil refiners make money buying crude oil and turning it into other products, such as gasoline. Generally cheaper feedstock is a good thing for such companies. The Market Vectors Oil Refiners exchange-traded fund (CRAK) holds a basket of such companies, but its volume isn’t particularly high. The three top holdings are Valero Energy Corp. (VLO), Phillips 66 (PSX) and Marathon Petroleum Corp. (MPC), which might make more sense for some investors. Still, like all stocks there may be adverse effects from non-commodity-related issues in the future.
If futures won’t do, and stocks aren’t quite right, what can you do? Sperandeo says go for the iPath Bloomberg Commodity exchange-traded note (DJP) which tracks a broad basket of commodities across agriculture, energy and metals, in roughly equal parts.
Another similar product is the iShares S&P GSCI Commodity-Indexed Trust (GSG), which tracks the Standard & Poor’s GSCI commodity index. However, that index is heavily weighted in favor of the energy markets, which may not give investors the cross-sector diversification that they want.