Commodities have been on a tear as investors have sought alternatives to the volatile equity market, but several market experts believe that now is still a great time to buy, even though prices are high. You don't want to bet the farm on these volatile investments, but a diversified bundle of commodities can provide a long-term hedge and some hefty returns.
Investors, who poured some $121.2 billion into commodities since the start of 2009, have been well rewarded. In 2010 alone, gold rose 29%, copper, 22%, and oil rose $24 a barrel. Despite these upticks, some experts expect this bull market in hard assets to last for the next several years.
"Once I saw China joining the World Trade Organization, I've been bullish on commodities—pretty much all commodities—because long-term, per-capita incomes will rise, not just in China, but in India, Indonesia and Latin America," says Jeff Saut, chief investment strategist at Raymond James. "As a result commodities will have the wind at their back."
Tim Parker, portfolio manager of T. Rowe Price's New Era Fund, agrees. "Hard asset cycles take a while to go around, because supply and demand can be out of synch for 10 to 15 years at a time," he explains. "After all, it takes a long time to find new ore deposits and to develop a mine or an oil well." The downturn in commodities in 2008 and 2009 was not a turn in the cycle, but rather a pause in the upward trend caused by the recession, he adds. "The same kind of thing has happened in earlier recessions. You get a pause, and then commodities take off again." Parker thinks commodities can keep rising for at least three to five years.
For example, oil has rebounded to the mid-$80-per-barrel range, but since "there isn't a lot of new supply coming on line over the next two years, it could rise further," he says. And a relatively cold winter in North America and Europe combined with growing demand in a recovering global economy, will boost oil and gas prices.
Meanwhile, infrastructure demands especially in the developing markets should drive sales of base metals and rising consumption in China, India and the rest of Asia, and in Latin America will boost crop prices, "People want to eat more and to eat more protein. So there's this nice demographic wind behind these commodities," says Parker.
Saut says that he thinks gold, despite already hitting record highs, will continue to rise, particularly as the dollar weakens long term. With the exception of platinum, which is heavily used for catalytic converters in vehicles, precious metals are viewed as a kind of currency, when paper currencies sink.
"In general if you believe that the dollar is going to weaken over time, commodities, most of which are priced in dollars, should do well," says Christian Hviid, chief market strategist at Genworth Asset Management. Gold also benefits from demographic trends that are leading to higher standards of living in developing countries, he says. "Eighty-five percent of gold is used for jewelry." Ironically, the biggest risk to gold prices could be that if the global economy starts to pick up, investors may shift away from the yellow metal to pursue greater gains in equities or other investments.
Not only can commodities, especially those priced on global markets in U.S. dollars, such as oil and gold, act as an inflation hedge, but because the gyrations of hard assets aren't usually correlated to equity and bond movements, they diversify stock and bond portfolios.
However, commodities can also be incredibly volatile, says Ron Florance, managing director for investment strategy at Wells Fargo Private bank. "You need to be diversified because while a 50% swing in equities is a once-in-a-lifetime event, it happens all the time to commodities."
Wells Fargo recommends commodities exposure for all its clients, but Florance warns that anyone who invests in just one commodity, whether it's gold, oil or wheat, had "better have a higher authority in his research department!" Wholly unpredictable events, such as a frost in the Southern U.S., an oil-well blow-out in the Gulf of Mexico or the announcement by a big country like China that it's tightening lending rules, can cause wild swings in one or even multiple commodities.
"It's not uncommon to see commodities with 6% to 10% daily swings," says Hviid. Even most professional investors won't try to time buying commodities, adds Katherine Young, a mutual fund analyst at Morningstar. "It's much better to hold a basket of commodities and invest long term."
A diversified basket of commodities would have outperformed a diversified equity portfolio over the past decade, says T. Rowe's Parker. He compared the broadly based Lipper Global Natural Resources Index with the S&P 500 Index for that time period and found that when the S&P 500 lost -0.4%, the Lipper gained 11.9%.
All of that was moot in the past three years, of course when commodities offered no protection to investors in the market crash of 2008, and the famous volatility of commodities can mean they badly underperform equities in the short term. In the last three years, commodities (-7.4%) matched the S&P (-7.2%), and in the past year, the Lipper index was flat while the S&P rose 10.2%.
For most clients, the best way to invest in commodities is probably mutual funds or exchange-traded funds (ETFs). Morningstar's Young suggests several mutual funds that offer broad exposure (see chart): Credit Suisse Commodity Return Strategy (CRSOX), which tracks the Dow Jones UBS Commodities Index, the Pimco Commodity Fund (PCRDX), a more energy-heavy fund that tracks the S&P Goldman Sachs Commodity Index and the Oppenheimer Commodities Fund, which also tracks the S&P GSCI and recently shifted its fixed-income holdings to short-term, high-quality government-backed bonds. Because of tax considerations, commodity funds typically invest up to 25% of assets in commodities futures and derivatives. They hold bonds as collateral to back those futures and derivatives, with the bonds providing some income, even when commodities fall.
On the ETF front, Morningstar analyst Abraham Bailin suggests several frontrunners: The U.S. Commodities Index Fund ETF (USCI), which seeks to smooth out daily fluctuations by investing in commodities futures with at least 12-month expirations; the Greenhaven Continuous Commodity Index ETF (GCC), which Bailin says "lowers the ETF's relative volatility and increase its risk-adjusted returns compared with owning a small sampling of handpicked commodities;" and finally, the PowerShares DB Commodity Index Tracking ETF (DBC), which offers a broadly diversified basket of commodities, while holding some that are less widely tracked.
How much should clients invest in commodities? From 4% on the low end to 10% on the high end say investment analysts, although Parker recommends 10% to 15% of a portfolio.
If clients don't own commodities but want to, Parker suggests buying tranches over time. "Spread it out over three or four tranches," he says. "Even if you don't get dips, buy over time, not all at once."
With signs of continued global economic growth, particularly in developing countries and with mounting U.S. deficits threatening the dollar, it may be a good idea to suggest clients who don't have commodities exposure buy that first tranche now.