Most financial advisors tell their clients to keep around 5-10 percent of their portfolios in commodities. The idea is that they act as a hedge to reduce volatility in investment portfolios. According to a 2010 study by Mercer et al. published in the American Association of Individual Investors (AAII)’s The Journal of Investing, “an allocation to commodities in a tactical asset allocation using monetary conditions consistently outperforms both a strategic commodities allocation and an all-equity portfolio” – but investing in commodities is not as straight-forward as it sounds.
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Many investors have misconceptions about commodities that either lead them to avoid commodities altogether or add more risk to their portfolios.
Here are some of the more common misconceptions investors have about commodities:
There is Only Way to Play
When it comes to investing in commodities, investors have several ways they can get in on the action. The physical commodity is always an option, but there are several choices besides. Investors may also invest in the resource producers. For instance, in addition to investing in gold, you could invest in gold miners.
Commodities are Singular Investments
Moreover, you do not have to invest in a commodity to get the benefit of having commodities in your portfolio. There are several mutual funds that provide direct exposure. You can choose to invest in a fund that lumps together different commodities. Oppenheimer Funds, Pacific Investment Management, and Pimco each offer commodity funds.
Commodities are Not Equities
While it is true that a commodity is not an equity, it does not mean that you cannot invest in them as they are. There are exchange-traded funds (ETFs) that give you access to commodities without having to actually invest in the commodity. Some include the physical commodity while others include a mixture of commodities and commodity producers. The idea here is that there are enough different inputs that if one producer hits a snag, it does not bring down your total return.
Popular commodity ETFs include iShares Gold Trust (IAU), iShares GSCI Commodity-Indexed Trust (GSC), PowerShares DB Commodity Index Tracking Fund (DBC), and SPDR Gold Trust (GLD). In the case of iShares Gold Trust and SPDR Gold Trust, they actually hold some gold bouillon in a vault.
Commodities are Risky
Commodities are not riskier than any other investment, and that risk considerably declines when you invest in commodities via diversified commodity funds or invest with a longer-term horizon. Most commodities will increase over time, given long enough. That said, the commodity market is filled with scam artists, so make sure that your broker is a member of the National Futures Association.
Commodities Can Have Big Returns
Do not invest in commodities thinking you are going to be able to work out a significant return. “Commodities are like dead money,” explains Rick Ferri, the founder of Portfolio Solutions LLC, in the Wall Street Journal. “They do not pay any interest or dividends and are not expected to earn any return over the inflation rate… Year after year it just sits there, costing you money in storage, insurance and perhaps a management fee if you invest in a gold ETF.” Terri continues by saying, “The only thing commodity funds have going for them is the hope that someone will pay a higher price in the future.” The thing that investors have to remember is that commodities lower portfolio risk because they are not correlated with stocks.
The Only Risk in Commodities is Volatility
Commodities are subject to volatility, but the risk you expose yourself to is going to be different depending on how you choose to invest in commodities. For one, all commodity-based mutual funds and ETFs have tracking errors. They are constantly tweaked, but the returns they produce is going to be different from that of the actual commodities. Alternatively, you can choose more direct exposure but if you invest in commodity producers, you have to absorb company risk, and if you invest in a managed account, you will have additional costs to consider.
Everyone Should Own Commodities
A well-diversified portfolio is always a good thing, but if you have a small portfolio or a very long investment horizon, you might not need to include commodities in your portfolio. Commodities are basically a way of adding inflation to your portfolio. This prevents losses from being as big as they could, but it also limits your portfolio’s returns. If you are in a position to take on increased risk, you really may not need the benefits commodities present.
A Little Commodity Goes a Long Way
That said, if you are risk-averse or want to significantly reduce your portfolio risk, you may need to invest more in commodities than your advisor thinks. According to the Mercer et al. study, “portfolio risk was reduced significantly when 10% or more of the portfolio was allocated to commodity futures. Interestingly, a 5% allocation to commodity futures was not sufficient to produce a significant reduction in risk for any of the five investment strategies.”
The study also found that “adding a commodity exposure enhances an equity portfolio’s return only during periods when the Federal Reserve is increasing interest rates, which is consistent with the belief that a major attraction of commodities is that they serve as an inflation hedge.”