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Do commodities investments pay off? – Sarasota Herald-Tribune

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Investors typically invest in three main asset classes: stocks, bonds and cash. But according to classical investment theory, “optimal” risk-adjusted returns require portfolios that are as diversified as possible. This leads some adventurous investors or their financial advisers to venture into commodities.

Investors are familiar with commodities such as gold, silver and oil. Few, however, understand how to invest in commodities, the pros and cons of such investments and how they differ from investments in more traditional asset classes.

Investors usually don’t invest in commodities directly. They instead generally invest either directly or indirectly in commodity futures. These are securities that are a short-term wager on the future value of a commodity. Indirect investments in commodity futures are available through exchange-traded products (ETPs), sector mutual funds and limited partnerships called managed future pools. It’s also possible to invest even more indirectly into commodities by buying stock in a company that produces the commodity.

Commodity futures are unlike stocks or bonds.

The purpose of stocks and bonds is to raise money for the corporation to invest. A bond can be valued by examining its interest rate and its probability of default. A stock can be valued based on its forecasted future earnings and dividends. These are all uncertain and investors are paid to bear this uncertainty.

The purpose of commodity futures is quite different. Their purpose is to allow firms to obtain insurance against the future value of their commodity. There is nothing to value — no earnings or dividends or interest payments. Investors are simply betting on the short-term price fluctuations of the commodity and are being paid to bear that risk.

The simplest way for investors to add the commodity asset class to their portfolios is through commodity index mutual funds or ETPs. The latter trades on a stock exchange just like any stock and the former just like any mutual fund.

Aside from being easy, their other advantages include low management fees, at least for ETPs, and high correlation with the price fluctuation of a commodity or market basket of commodities. Some commodities have ETPs or commodity index funds that follow them.

Wealthier investors can invest in a limited partnership that employs a proprietary managed-futures strategy. The advantage is professional advice rather than a simple indexing strategy. The disadvantages are generally high fees, a limited ability to evaluate how the strategy has historically performed and illiquidity.

So is it worth doing?

This is a judgment that each investor, alone or with an adviser, must make based on the investor’s risk tolerance and return requirements, but studies provide data and insight.

The past decade has not been good for commodities; for example, the Powershares commodity index tracking fund “DBC” had an annualized return of -5.2 percent. Commodities have demonstrated high volatility and returns that varied dramatically. Coal was the most volatile, with returns varying from +104 to -17 percent; gold was the least volatile, with returns varying from +37 to -28 percent. The best performer was palladium and the worst performer was nickel.

One study of the period 1959-2004 by Gary Gorton and K. Geert Rouwenhorst provides perhaps limited insight into the possible very-long-term value of commodities. They reported that an equally-weighted index of commodity futures had returns similar to the S&P 500 with lower volatility and was negatively correlated with stocks and bonds and positively correlated with inflation.

Send comments and questions to Robert Stepleman, Dow Wealth Management, 8205 Nature’s Way, Lakewood Ranch, FL 34202, or rsstepl@tampabay.rr.com. Follow him on Twitter @logicalinvestor. Stepleman is associated with Dow Wealth Management LLC as a lecturer and chief portfolio strategist. He offers advisory services through Bolton Global Asset Management, an SEC-registered investment adviser. Past performance is not indicative of future results. The data and performance information is for informational purposes only and is not intended as a solicitation.