Jumping on the Commodity Bandwagon

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In times of great market turmoil, it's not uncommon for investors and professional money managers alike to reevaluate their approaches to investing. After what's happened to the market and the economy in recent years, a lot of people are making tweaks and adjustments to their portfolios to make up some of that lost ground and better position themselves for what's next. Unfortunately, many of these same individuals may end up making moves at exactly the wrong time, which could end up costing them.

Following the money
It's no secret that retail investors and no small number of professionals are prone to performance-chasing behavior. History has shown that once particular asset classes or segments of the market begin to outperform, the money follows the returns, fast and furious.

The latest group getting in on the act appears to be target-date funds, many of which are now beefing up on their exposure to commodities. While many managers are undoubtedly adding these commodity positions to help reduce volatility in the portfolio, I'm equally sure that many are simply chasing performance, especially since many individual commodities, notably gold, have done extremely well in recent years.

Target-date funds are marketed as one-stop shops for investors who lack either the knowledge or the desire to build a portfolio of individual mutual funds or stocks. These funds typically invest in a range of other mutual funds from the same fund family, and attempt to build a diversified portfolio. Over time, the fund manager adjusts the allocation within the fund, stepping down equity exposure and increasing fixed income as the investor gets closer to retirement.

Target-date funds have become increasingly important in the investment world, since many retirement plans use them as default options to automatically enroll plan participants. That means more and more people are likely to use target-date funds as their primary tool for saving for retirement.

Hurry up to catch up
If you own a target-date fund, make sure you know whether your fund is moving into commodities. You should be able to get details on the underlying holdings in your fund, so check to see whether your fund owns any commodity or "real return" funds. A small allocation probably won't be too dangerous, but if you've noticed a marked increase in recent quarters, you might want to consider switching to another fund. A hefty commodity allocation likely means that the manager is looking to play catch-up with returns, rather than simply aiming to diversify the portfolio.

Fund families that have not added commodity exposure to their target-date funds include American Century and Vanguard. If you've got some flexibility in your retirement plan, consider checking out their lineups of target-date funds. But even if you don't have a lot of fund options in your employer-sponsored retirement plan, or you don't want to move out of your current target-date fund, it will help to simply be aware of how much commodity exposure your fund has. That way, you'll have fewer surprises down the road if this asset class zigs or zags any certain way.

A balanced view
In general, I'm still not convinced that commodities are an essential part of any investor's portfolio. Historically, most commodities have simply not produced enviable long-term returns. Of course, most folks like to tout commodities' diversification benefits. And while that may have been true in the past, recent data have shown that commodities are becoming more and more highly correlated with equities. A study by RS Investments earlier in 2010 noted that in more recent years, diversification results for commodities have been mixed. Apparently, commodities' correlations with inflation have remained strong, but their correlation to stocks has been on the rise, reducing their potential diversifying powers.

However, if you still want to take a chance on commodities, the best thing you can do for your portfolio is to keep your overall allocation low, ideally no more than 5%. If you're looking for broad exposure to commodities, your best bet is a low-cost exchange-traded fund like the PowerShares DB Commodity Tracking Index (NYSE: DBC  ) or iShares S&P GSCI Commodity-Indexed Trust (NYSE: GSG  ) . If you want to target gold in particular, a big favorite right now, SPDR Gold Shares (NYSE: GLD  ) or iShares COMEX Gold Trust (NYSE: IAU  ) are both good choices.

Of course, even if you don't want to buy commodity ETFs, you can still harness some of the power of this corner of the market by purchasing commodity-related stocks. For example, buying Freeport-McMoRan Copper & Gold (NYSE: FCX  ) or Newmont Mining (NYSE: NEM  ) would be one way to play the gold and precious-metals market. Likewise, megacap ExxonMobil (NYSE: XOM  ) would help provide indirect exposure to the ups and downs of the price of oil. Odds are you've got some decent commodity-related exposure in your portfolio already, even without a targeted commodity fund.

So even if commodities do well as an inflation hedge in the coming years, they should be used sparingly and cautiously. If you're a target-date fund investor, or even an investor in a fund that gives your manager wide latitude, make sure you have an idea of how much exposure you have to this corner of the market.

For more insider investing and personal financial planning tips, check out the Fool's Rule Your Retirement service, which provides top-notch retirement and mutual fund advice. You can start your free 30-day trial today.

Amanda Kish is the Fool's resident fund advisor for the Rule Your Retirement investment newsletter. At the time of publication, she did not own any of the funds or companies mentioned herein. The Fool owns shares of ExxonMobil. The Fool has a disclosure policy.

Read/Post Comments (1) | Recommend This Article (5)

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Help us keep this a respectfully Foolish area! This is a place for our readers to discuss, debate, and learn more about the Foolish investing topic you read about above. Help us keep it clean and safe. If you believe a comment is abusive or otherwise violates our Fool's Rules, please report it via the Report this Comment Report this Comment icon found on every comment.

  • Report this Comment On August 24, 2010, at 5:32 AM, MorganEllis wrote:

    Thanks Amanda, nice to see a piece on commodities! Not too many comments though which does not surprise me as many readers are probably focused on stocks here.

    Up until a few years ago I dismissed commodities (also referred to as hard assets) as mere speculation, but after following Jim Rogers lead I started to take it more seriously. Jim's arument is basically demand/supply ... i.e. emerging economies like China/India are hungry, and there is finite supply. Prices must trend up.

    I've read research by Roger Gibson on multipe asset class investing (diversification including stocks, bonds, property AND commodities). In the past, commodities have been superior to stocks at different points in time. He shows that adding commodities to a portfolio over longer periods of time, reduces risk/volatility and increases returns. Here's what Gibson said in an interview with "Foolish" Robert Brokamp in 2008:

    "The bottom line is if you had put a dollar in U.S. stocks, held it from '72 through 2005, and continually reinvest your income, you'd have $36.53. A dollar solely invested in the Goldman Sachs Commodities index grows to $47.56. However, a 50-50 portfolio, annually rebalanced between the two, a dollar grows to $61.89".

    Research by Yale School of Management’s Center for International Finance concludes:

    "Since 1959, commodities futures have produced better annual returns than stocks and outperformed bonds even more. Commodities have also had less risk than stocks and bonds, as

    well as better returns". Futhermore:

    "Investing in commodities is an important asset class that cannot be overlooked".

    There is some debate about WHICH commodities to hold! Yale says you get better returns buying futures (substitute commodity index funds), while other like Jeremy Siegel say companies that mine or produce the commodities are better.

    I'm not a big gold fan, except for a small holding of coins as a hedge against the unlikely event of hyper-inflation where the global economy disintegrates! But, other than gold I believe a basket of commodities (agricultue, energy, metals) should be part of a portfolio.

    For me it's all about long term investing. Stocks are risky when you take a view of less than 7-10 years .. commodities are no different.

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