Counting on commodities as an investment

/ Source: contributor

If only we’d had the foresight to stock up on lead. With just a few hundred tons of it we’d be sitting pretty today.

That’s right, the stuff of bullets and batteries. Lead prices have soared nearly 60 percent this year, due to increasing demand worldwide and production difficulties in China, the largest producer.

Lead is just one of a vast array of commodities that have done well in recent years. Corn is up nearly 70 percent in the past 12 months, largely due to its growing use to make ethanol for fuel. Soybeans are up nearly 40 percent in the past year. And so on.

The Dow Jones-AIG Commodity Index, though relatively flat recently, has produced average annual returns of about 9 percent over the past decade. It is composed of 19 commodities, from aluminum to cotton and natural gas to zinc.

Should small investors try to get in on the commodities boom?

Many are, using a battery of products that relieve you of the need to own a grain silo, warehouse or cattle ranch. Commodities investing gets easier by the day, it seems, with new mutual funds and exchange-traded funds that are a lot simpler to handle than futures contracts.

Still, commodities are not for the faint hearted. At the moment, the overarching question is: Is it too late? Anytime an investment has had a big run-up, as commodities have over the past few years, a new investor risks buying at the peak and losing money when prices pull back.

That said, many experts do believe that commodities deserve a place in the small investor’s long-term portfolio — generally no more than 5 to 10 percent.

Commodity prices are notoriously fickle, as they are driven by international forces that are devilishly hard to fathom. They are influenced by everything from rainfall to environmental and health issues to international relations.

Right now, for example, oil prices are being buoyed by a workers’ strike in Nigeria and Iran’s soured relations with the West.

But there’s a good side to this. Because the factors driving commodity prices are different from those governing stock prices, commodities often rise when stocks fall, and vice versa. That makes commodities a good way to diversify a portfolio, or spread out risk.

A recent study by finance professors Gary Gorton of the Wharton School and K. Geert Rouwenhorst of Yale found that a basket containing 40 commodities would have returned an average of 10 percent a year from 1959 through 2004, about the same as the Standard & Poor’s 500 index of large-company stocks. Commodities tended to do well when stocks were sagging, the professors found, because commodities benefit when inflation is high, while inflation hurts stocks.

So how do you invest in commodities?

The purest way is through futures contracts. These are standardized agreements to buy or sell fixed amounts of given commodities at a set price on a future date. A contract for pork bellies, for example, calls for the purchase or sale of 40,000 pounds of bacon.

If you invested in a contract to buy pork bellies, you would hope for bacon prices to rise, driving up the value of your contract. By investing this way, you would not have to take delivery of all that bacon. You would simply buy and sell the contracts.

But this is tricky. Because a futures contract expires on a set date, you can’t simply wait out a downturn as you can with stocks. Futures trading is done through a “futures commission merchant” or FCM, which is similar to a stock broker. You can find them with your search engine, but first read the cautions listed by the U.S. Commodities Futures Trading Commission.

If you want to dabble in futures, start small and avoid leverage, which means borrowing from the FCM the bulk of the money you invest. It can supercharge your gains – or wipe you out if you bet wrong.

Another approach is to hire a Commodity Trading Advisor, or CTA, an expert who will trade futures on your behalf, or to use a Commodity Pool Operator or CPO, who will pool your money with that from other investors, who will share the profits or losses. Bone up on this industry through the National Futures Association Web site.

The simplest way to invest in commodities, and probably the best for small investors, is to pick a commodities mutual fund.

One of the best known is the PIMCO CommodityRealReuturn Strategy Fund, designed to track the Dow Jones-AIG index. It’s up about 5 percent this year, while S&P 500 funds are up more than 8 percent

Another is the Oppenheimer Commodity Strategy Total Return Fund, which tracks the energy-heavy Goldman Sachs Commodity Index and is up about 3 percent this year.

Check out these and other commodity funds at the Web site of market-data firm Morningstar Inc. Key either of those ticker symbols into the Similar Funds function under the Tools button and you’ll generate a list of nearly 40 commodities funds. Be sure to read Morningstar’s analysts reports for a discussion of risks before investing, and watch out for high “loads” or sales commissions.

There also are a growing number of exchange-traded funds tracking commodities. The best known is the PowerShares DB Commodity Index Tracking Fund, which follows the Deutsche Bank Commodity Index, composed of crude oil, heating oil, aluminum, gold, corn, and wheat. It’s up about 4 percent his year.

A similar product is the exchange-traded note, such as the iPath Dow Jones-AIG Index Tracking ETN, a product of Barclays Bank, which promises to match the return on the Dow Jones-AIG Commodity Index, less a 0.75 percent annual fee.

This and other ETFs and ETNs can be purchased through a broker, just like any stock. On the Morningstar site, go to the ETF screening function under the ETF button and run screens for natural resources and precious metals funds. You’ll have to sift the results to find ETFs that invest directly in commodities, typically through futures contracts, rather than funds that buy stocks in natural resources or mining companies.

On the other hand, those stocks-based ETFs are not a bad idea. A fund containing oil-company stocks is likely to mirror the rise and fall of oil prices, for example. (By the way, there is a class of stock-like products called Master Limited Partnerships that invest in commodities infrastructure such as oil and gas pipelines. Examples are Kinder Morgan and Enterprise Products. They’re worth a look)

Whatever approach you choose for commodities investing, start small. Commodities are volatile. And once again, it’s always risky to jump into an investment after it’s had a big run-up.