Investors looking for the optimal way to play the markets have found that a diversified portfolio is truly the best way to allocate assets. Diversification spreads risks while granting exposure to various corners of the market that behave quite differently depending on the current environment. For quite some time, the biggest debate has not been whether investors should diversify, but how to do it. Many fight over allocations to two asset classes; equity and fixed income, as these two are the traditional mainstays of any portfolio. While finding the right balance between the two can have a major impact on your portfolio, there is one asset class that many investors overlook; commodities.
It used to be that commodity exposure was left primarily for active traders, as complex and risky futures contracts were the primary way to allocate to these investment options. Now, with the help of the rapidly expanding ETF industry, investors can establish a long term exposure to commodities without having to play the futures markets by trading on margin. There are exchange traded products that execute a roll process on a monthly basis to maintain constant futures exposure and there are also ETFs that offer physical exposure to a particular commodity like gold. These options have only just emerged in the past few years, leading many investors to be skeptical of commodity exposure as a part of a long-term portfolio, but these investments offer a wealth of opportunities for traders [see also Analyzing Five High Yielding Oil & Gas Pipeline Stocks].
Commodity Benefits
Commodities help investors hedge against the nasty effects of inflation, as the prices of these resources tend to rise parallel to inflation. Broad-based natural resource exposure can provide access to an asset class that should perform well in such environments. Now that the Fed has announced that it plans to hold its rates at virtually zero through mid-2013, inflation fears are higher than ever, as any kind of uptick of an inflationary environment cannot be battled with interest rates for nearly two years. Commodity exposure will allow investors to account for inflation in both the long and short run in their portfolio which is especially important given the current outlook for the U.S. economy. Also consider that the supply of commodities is limited in a sense; while farmers can grow less or more of a certain crop, commodities themselves are not subject to the inflation that currencies and equities experience when it comes to adding money to the system like one of the quantitative easing programs [see also Ultimate Guide To Copper Investing].
Another major benefit offered by investments in these resources comes from their low correlation to stocks. While there are numerous companies, like miners, who find themselves somewhat anchored by commodity prices, the commodities themselves have little to no relation to equity markets. This means that on a day that all of your major equity holdings are down, it is very possible that your commodity exposure could be paring losses with steady gains. The idea of a well-diversified portfolio is to have low correlation in order to spread risks, and with some commodities exhibiting almost zero correlation to stocks, there is no question that they have a place in your portfolio [see also Precious Metals ETFs: Finding The Best Fit].
Still not convinced? Consider then the emerging markets of the world. The majority of commodities are consumer goods that are being gobbled up by emerging markets that are experiencing exponential population growth, and as the years go on, demand for these goods will likely only increase. The world population is currently sitting just under seven billion, but by 2050, that figure is expected to increase to an astonishing 9.2 billion, meaning that there will be a lot more mouths to feed and much higher demand for these commodities. This presents many of these investments as a possible growth opportunity to make a play on population growth and the inevitable surge in global demand.
How To Use Them In Your Portfolio
While commodities are an important cornerstone of any respectable portfolio, they do not deserve a major allocation. Commodities can be dangerous investments as they are typically subject to high volatility and can be incredibly unpredictable. For all of the benefits they provide, commodities can also be a major thorn in an investors’ side, leading many to consider them as a necessary evil as their day to day returns can stray by hundreds of basis points, disqualifying them from a major portfolio allocation.
Instead, they should be used as something a compliment investment and account for anywhere between 5% and 10% of your portfolio depending on your particular strategy. As for which commodities to pick, there is a laundry list to choose from, including crude oil, natural gas, gold, and more obscure options like orange juice, canola oil, and even butter futures. Investors can trade futures contracts if they can stomach actively moving positions, but the best option for a buy-and-hold investor is to purchase a broad-based ETF that features either physical exposure or an automated roll process [see also Commodity ETFs: Five Factors To Consider].
When it comes to broad based exchange traded funds there are numerous options that deserve close inspection like DJP, GCC, DBC, and DBA, all of which employ a futures-based strategy. For those looking for physical exposure, products like GLD, SLV, and GLTR may work better for their investment style. Despite how you decide to add commodity exposure to your portfolio, one thing is certain; it is a vital component of any self-respecting diversified basket of holdings and should be embraced by buy-and-hold investors and traders alike.
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Disclosure: Photo courtesy of Robert Knapp. No positions at time of writing.
[...] Commodity investments come in all shapes in sizes. While futures are arguably the most popular way to obtain exposure to your favorite commodity, there are numerous other options out there. There are a number of exchange traded products that offer exposure to futures, as well as physical commodities like the SPDR Gold Trust (GLD), which invests in physical gold bullion. Finally, there are commodity stocks, which generally consist of mining and exploration companies like BHP Billiton. This latter option may be particularly attractive to investors seeking high yields, but still want to reap the benefits of commodity exposure in their portfolio [see also Why Commodities Belong In Your Portfolio]. [...]
[...] Widespread commodity exposure in a portfolio is relatively new as far as the financial world is concerned, as investors are beginning to see the advantages of adding this key element to their basket of securities. While it is true that these investments probably do not warrant an allocation higher than 5%-10%, they can have a significant impact on a portfolio and come with a long list of advantages. These investments help to hedge against inflation, as their prices tend to rise as currencies slowly devalue, and they are often the first items to gain because producers can easily pass on costs to those further down the supply chain. Also consider that the supply of commodities is limited in a sense; while farmers can grow less or more of a certain crop, commodities themselves are not subject to the inflation that currencies and equities experience when it comes to adding money to the system like one of the quantitative easing programs [see Why Commodities Belong In Your Portfolio]. [...]
[...] Despite being the largest gold miner, the company also has significant operations in copper and silver as well. The company derives about 80% of its profits from gold with around 19% coming from copper, proving the significance of the industrial metal to the company’s bottom line. As far as gold breaks down, North and South American Mines account for for roughly 60% of production while Australian and African mines make up the majority of the rest [see also Why Commodities Belong In Your Portfolio]. [...]
[...] There has been a significant amount of research conducted suggesting that commodities can be a valuable addition to investors portfolios. And the impressive returns generated by this asset class historically serve as further evidence of the tremendous potential of commodities. But commodities are complex assets, and the options investors have for accessing this asset class are often nuanced and difficult to grasp. Moreover, under the commodities umbrella are dozens of resource families and specific hard assets, many of which feature risk/return profiles that are drastically different from other commodities [see also Why Commodities Belong In Your Portfolio]. [...]
[...] As interest in commodities as an investable asset class has increased in recent years, more and more investors have sought to educate themselves on the various ways to establish exposure to natural resources and the factors that impact prices of various investment vehicles. Many have embraced ETFs and ETNs as efficient options, gravitating towards low cost vehicles that offer low maintenance strategies and potential tax efficiencies. And while a prolonged rally in commodity markets has delighted many investors, some have expressed frustration over gaps between exchange-traded commodity products and hypothetical spot returns [see also Why Commodities Belong In Your Portfolio]. [...]
[...] Natural gas may have appeal as an investable asset for several reasons. First, because long distance transport is expensive and challenging the fuel is impacted more heavily by supply and demand in the U.S. That insulates natural gas from external factors, such as geopolitical tensions elsewhere in the world. Natural gas can also exhibit significant volatility, especially following the release of inventory data. That may give natural gas appeal to short-term traders looking to profit from surprises in storage figures. Finally, some see natural gas as a component of a longer-term investment theme that includes decreasing dependence on foreign oil. Because natural gas is cheap, relatively clean, and found in abundance in the U.S., it is expected to gradually comprise a larger portion of the domestic energy equation [see also Why Commodities Belong In Your Portfolio]. [...]
[...] Nonetheless, BHP gave a rather solid outlook for investors for the rest of the year, suggesting that robust levels of demand for its key products could persist in many rapidly developing emerging markets. “We expect robust demand in the short-and-medium term, supported by commodities-intensive emerging economic growth,” the company said in a statement. “A more positive demand dynamic remains a distinct possibility should policy be enacted to further stimulate growth in the developed world.” This is especially true for iron ore and coal, two key ingredients in the production of steel that BHP is a market leader for. Given the high levels of demand in countries such as India, China, Indonesia, the company’s continued ability to extract more of the product from the ground has been nothing but good news for the firm’s bottom line and could continue to drive earnings for years to come as these nations go further down the path of industrialization. “The profit margins and the earnings growth through production growth that we’re seeing from the mining companies make us actually very bullish.” said Catherine Raw of BlackRock after the company’s earnings release [Why Commodities Belong In Your Portfolio]. [...]
[...] Commodity investing can be an expensive venture, and if one is not careful, it can be easy to erase value through expenses like commissions and other fees associated with trading. One of the first things every investor should do is take a look at their strategy and then research if there is a cheaper way to gain the exposure. Often times, there is a corresponding exchange traded product to a futures-based strategy that can offer a much more enticing expense structure. The constant shifting of positions required by commodity investing can quickly eat away bottom-line returns, as commission fees rack up quickly, not to mention the capital gains on a short term trade. Failing to consider one’s expenses is essentially allowing the markets to steal from you [see also Why Commodities Belong In Your Portfolio]. [...]