Smart Advice for the HuffPost Investor: Investing in Commodities -- Smart Move or Fool's Gold?

Question: Is now the right time to invest in commodities?

Answer: With oil prices reaching record highs almost daily, it is no wonder that assets in commodities funds have exploded to $260 billion.

Adding commodities as a separate asset class to your portfolio can be justified if doing so reduces risk, increases returns or acts as a hedge against inflation.

Unfortunately, the data on whether it accomplishes any of these objectives is conflicted.

One private study used the Goldman Sachs Commodity Index (GSCI) and reached these conclusions:

-- There was no excess return over T-Bills from adding the GSCI to portfolios;

-- There was no reduction in the volatility of a stock and bond portfolio when the GSCI was added; and

-- Adding the GSCI did not improve protection against inflation.

However, there is some historical data indicating that adding commodities to a broadly diversified portfolio of stocks and bonds increased returns and lowered risks. One study found that, over a 20 year period, a mix of energy, real estate and metals and mining funds, achieved these goals.

If you are persuaded by the positive data on commodities, you could consider index funds like the iPath Dow Jones AIG Commodity Index Fund (DJP) or the iPath GSCI Total Return Index Fund (GSP).

DJP is less volatile and more diversified. GSP has a large percentage of its assets invested in oil and gas (which explains why is up 24.05% in the past year!).

Personally, I am content with the commodities exposure I receive by owning a broadly diversified domestic index stock fund. I do not have exposure to commodities as a separate asset class in my portfolio and I do not recommend it for inclusion in the portfolios of my clients.

Question: What are the past performances of these world index stock and bond funds and compared to what ? Are you assuming that all emerging and all world markets in aggregate will go up with time in the future as the U.S. market did in the past ?

Answer: For the period 1986-2007 (when the most reliable data is available), the world portfolio generally under performed the Smart Investor portfolios which are set forth in The Smartest Investment Book You'll Ever Read.

For example, a 60% (stocks) and 40% (bond) portfolio consisting of a mix of the Vanguard Total Stock Market Index Fund (VTSMX), the Vanguard total International Stock Index Fund (VGTSX) and the Vanguard Total Bond Index Fund (VBMFX) had an annual return of 10.09% during this period. The world portfolio had an annualized return of 9.87.

The Vanguard portfolio had 100% domestic bonds. The world portfolio has a majority of its funds invested in foreign bonds. During this period, domestic bonds out performed foreign bonds.

Let's put these returns in perspective.

One study showed that, for the 20 year period from 1986 through 2006, the average equity investor earned only 4.3% on her investments. During that same period, the S&P 500 had an annualized return of 11.8%.

I am making no assumptions about the direction of either the foreign or the domestic markets. Historical data tells us that the global markets in the aggregate have increased in value in the past. We also know that broad asset class diversification is a critical element to investing success.

Investors who believe that global diversification of the stock and bond portion of their portfolios is preferable to a portfolio of globally diversified stocks and domestic bonds would be well advised to consider a world portfolio.

Either choice would have yielded a return more than 200% better than the returns of the average equity investor, who was following the advice of her "market beating" broker or advisor.


The views set forth in this blog are the opinions of the author alone and may not represent the views of any firm or entity with whom he is affiliated. The data, information, and content on this blog are for information, education, and non-commercial purposes only. Returns from index funds do not represent the performance of any investment advisory firm. The information on this blog does not involve the rendering of personalized investment advice and is limited to the dissemination of opinions on investing. No reader should construe these opinions as an offer of advisory services. Readers who require investment advice should retain the services of a competent investment professional. The information on this blog is not an offer to buy or sell, or a solicitation of any offer to buy or sell any securities or class of securities mentioned herein.

Comments

[outnow]

Sorry:

http://www.zmag.org/zmag/viewArticle/17820

[outnow]

Read Market Madness by A.K. Gupta at: http:/www.zmag.org/view Article/17820

Warren Buffet moved into food commodities sometime back. This article gives some insight into the problems and the potential profits in options and futures in commodities. The daily movements in some of these commodities are more than annual movements used to be due to a number of factors which Mr. Gupta explains. That is why the author of the post cautions the investor. Invest at your own risk.

[Halsey]

I would say..there is a HUGE difference between buying a commodities fund (which much go long)..and putting say 5% of your portfolio in MANAGED FUTURES....they can short, go long..etc.

I put my clients with a great manager...who was up 59% last year...and annualizes at 20% over 10 years..(yes...he's also been down 20% in 2000!..so...you have to stay in for the long run!!!)..

These guys EARN the 1.5% fee they make a year!..and if I could..I'd post the chart that shows that managed futures actually decrease the standard deviation of any equity portfolio..and are non-correlative to the market..(very important)..could go down in a bull market...but not necessarily...could go WAY up (which they have...in a bear... just a great addition...but...the funds....no way...

[wayoutleft]

as vague laymen's generalities go, you can count on the structure of the oil market to allow for profit-taking. at some point oil and other commodities will drop sharply enough to give short players- insiders who are now probably buying $120/bbl contracts- a chance to realize cash profits. i think what they're counting on is late money buying commodities at current prices or higher. that doesn't mean you won't have solid ten-year strategies in the scenario- but supply-demand logic won't cut it as an analytical tool for commodities. i think currency is the first area to understand before considering commodities. (so my smart guys tell me when i ask such questions. and they are definitely taking care of me. they got me out of tech and into utilities futures before the late '90's collapse.) p.s. to correct any impression that i am wealthy- which is why these things are quite important.

[Aaror]

Another point to consider on commodities is "where is the bubble?" A lot of times people will see an area rise, and will invest in it hoping the rise continues, this leads to an asset class rising above it's true value, followed by the inevitable crash as market forces reassert the value of the asset (in risk/reward terms).
If you bought Tech stocks when they were flying high you know what I mean.
So before you rush out and buy commodities, ask yourself, "is this asset really worth more than I'm paying for it?" If the answer is no, I'd look for a "bargain," instead. An example, when oil was being pounded at the beginning of this century the refineries went down too, so I put a few grand in them. Just sold that last year for 10X profit.
Another thought, buy an index fund of companies which produce/sell the commodities you want, you will prosper when those items go up, but you will have less risk as the company will still be worth something if the commodity becomes cheap.
Note that the profit on the oil refinery was a one time, "luck," gain, I still prefer index funds, but throwing a few grand at something from time to time can be fun, and it may pay off.

[emerywood]

To include foreign or world index funds and to call that diversification is a bit puzzling to me. Isn't the word " diversified " mean when one category of asset falls, the other would go up to obtain sort of a balance to compensate. How would the world stock or bond index funds compensate any decline in the domestic portfolio since there has not been any evidence of decoupling between the foreign and domestic markets, at least for now ?

[seawolf77]

Exploded to 260 billion. That's a bit disengenous don't you think in a 100-150 trillion world economy. And this is the most valuable asset in the world.

[cktirumalai]

I have some money in a Commodities Fund, which has gone up and down in recent months, but I am a bit uneasy about it because it seems speculative in a rather undesirable way. Also, it seems to move between two relatively fixed low and high points (covering a lot of ground) instead of ever developing a firm foundation below which it cannot go.

[dadw5boys]

check out DARK POOLS -- you should be afraid they are trying to privatize the worlds energy futures market.