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Commodities are hot. And although such popularity risks sweeping people up into an investing craze, it also helps spur new low-cost investment products. The latter development, at least, is good for investors. Commodities have two key virtues: They help diversify portfolios, and they help hedge against inflation. Investors still need to be careful about this volatile asset class — those who grab after hot money often get burned — but the availability of these commodities in lower-cost forms makes them a useful part of a portfolio in a reasonable amount. Commodities are tangible products: fuels such as oil and natural gas, precious metals like gold and silver, industrial metals such as aluminum, and agricultural products such as wheat, orange juice, and livestock. Few investors want cattle or corn delivered to their offices, so commodities investing for individuals typically entails trading in futures — essentially, contracts that bet on the future price of a commodity. Commodities have proved popular in the last decade. Trading volume on U.S. futures exchanges has quintupled over the last 10 years, notes one Commodity Futures Trading Commission official. And the value of assets invested in commodities has reportedly grown by about 10 times. What’s going on? Why are so many people interested in commodities? Some of this may just be the latest fad or people chasing the recent good returns — neither of which is a sound reason to invest in commodities. But there are sensible reasons why wiser investors might still wish this asset class to be a part of their portfolios. WHY COMMODITIES? A chief reason for investing in commodities is the diversification they bring to a portfolio of stocks and bonds. When stocks and bonds fall in value, commodities are more likely to rise, and vice versa. Or, to put the matter more technically, data from Gary Gorton of the University of Pennsylvania and K. Geert Rouwenhorst of Yale University show that commodity futures had a negative correlation over five-year periods with both stocks and bonds. As Jean-Francois Plante and Mathieu Roberge explain in May’s Journal of Financial Planning, the economic factors driving the commodities market are “completely different” from those of the bond, stock, and real estate markets. “As a result,” they say, “the correlations of commodities with other asset classes are very low.” And investments that perform in opposing ways can reduce a portfolio’s volatility. Commodities tend to help investors weather high and unexpected inflation. And the risk of high inflation in our future is not trivial. Laurence Kotlikoff and Scott Burns warn in their book The Coming Generational Storm (2004) that unfunded entitlement programs like Medicare and Social Security could easily result in inflationary pressures as the federal government struggles to fund these benefits in future decades. Nevertheless, it’s important to remember some cautions — warnings that I fear sometimes get downplayed in the current rush into a hot product. Commodities, like stocks, tend to be volatile. In 1998, for example, one commodities index lost more than 20 percent. More broadly, from January 1991 to May 2004, another commodities index had an annualized standard deviation of almost 18 percent, compared with less than 1 percent for Treasury bills (one of the safest investments). If you buy commodities, be prepared for a roller-coaster ride. Moreover, commodities have gone through times when they returned far less than stocks. From 1945 to 2001, for example, their annual return was about 6 percent, as compared to 12 percent for U.S. stocks. (That’s the downside of that negative correlation.) Some also question whether the past benefits of commodities will persist. Investment manager Gene Hochachka, for example, argues that the relationship between commodities and inflation may not be statistically significant. He says that commodity futures have little if any strategic investment value. Financial manager William Bernstein concludes in a 2006 article that much of the past benefit resulted from futures trading involving farmers trying to protect themselves against deflation. Today, however, commodity investors want protection against inflation, and the historical benefits may no longer apply (because of a lack of Keynesian normal backwardation, if you’re really into this stuff). Bottom line: With commodities, as with all investments, past performance is no guarantee of future results. Be careful, and don’t get too excited. HOW MUCH? So how much should you invest in commodities? One conservative answer is 5 percent of the portfolio, and that’s about what I’ve done. Other assets (including Treasury Inflation Protected Securities, real estate investment trusts, and stocks in precious metals, natural resources, and energy companies) can also help with inflation, and my inclination is to diversify extremely broadly across all asset classes in case any one does poorly. But some data indicate that investors could profit from a much higher allocation to commodities. For example, Plante and Roberge found that from 1970 to 2006, adding commodities to a traditional stock-and-bond portfolio would reduce risk, even up to a portfolio that was 45 percent commodities. I would not recommend putting 45 percent of your savings in something as volatile as commodities, but they also found that an allocation of 24 percent would have reduced the risk level of the traditional portfolio by as much as 13.5 percent, while also improving returns. Dean Fikar, a retired doctor who runs a financial Web site, has also explored whether commodities can allow investors to safely withdraw more from a retirement portfolio. He found that, under certain conditions, a commodity allocation of 20 percent permitted a withdrawal rate of 5.6 percent. This is a big advantage over the traditional rate of 4 percent. In short, if you’re comfortable with the volatility of this asset class, an allocation greater than 5 percent could be reasonable. But don’t forget the significant risks. A broadly diversified portfolio keeps investors out of all sorts of trouble — and not just with commodities. GETTING BETTER If you want to invest in commodities, how do you do so? Once, investing could mean buying large futures contracts or paying someone else to trade them. To reach more investors, mutual fund companies started offering commodity funds. There aren’t a lot of these, but among them are the PIMCO CommodityRealReturn Strategy and Oppenheimer Commodity Strategy Total Return funds. Some versions of such funds have sales commissions (boo! hiss!) or high annual costs, though one version of PIMCO’s fund for larger investors has an annual cost of 0.74 percent. One new investment product, introduced in June 2006, offers another way to hold commodities, possibly in a more tax-friendly manner. iPath offers exchange-traded notes (known as ETNs), which are unsecured debt securities from Barclays Bank linked to a commodities index. The company believes that investors will pay only capital gains or losses upon a sale, though the Internal Revenue Service has yet to decide. These ETNs have an expense ratio of 0.75 percent, which isn’t bad for this asset class (though nowhere near the 0.10 percent available for stock indexes). The ETNs track either the Goldman-Sachs Commodity Index (more concentrated in energy) or the Dow Jones-AIG Commodity Index (which I hold because of its broader diversification). Commodities have a ways to go before individual investors can buy them as cheaply and efficiently as they buy large U.S. stocks. But the products seem to be improving and, ideally, they will get even better in the future. For their likely diversification benefits and possible protection against inflation, commodities are worth considering. Just don’t go hog wild.
Robert L. Rogers, associate opinion editor at Legal Times , writes the Legal Tender column on personal finance. E-mail Rob with comments or suggestions for future columns.

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