Why You Should Consider Commodities in 2014

Commodities as a whole have underperformed stocks, bonds, and cash for three consecutive years. Will 2014 be a good year to add commodities to your portfolio?

Jan 7, 2014 at 1:38PM

Investing is not just about buying and selling securities; it is also about buying and selling asset types. Given the aging bull market in stocks, downside pressure on bond prices, and near-zero yields for cash, asset allocation in 2014 will be a challenge, to say the least.

Tactical asset-allocation in 2014
With a tactical approach to your portfolio structure, you will have a target allocation, but you may sometimes find yourself "overweight" some assets and "underweight" others. For example, let's say your target asset allocation is 70% stocks and 30% bonds. In an environment where those assets are growing overpriced -- as is arguably the case now -- you might decide to underweight those assets and overweight cash.  For example, in 2014, your allocation may be 60% stocks, 20% bonds, and 20% cash.

Commodities as an alternative asset and diversification tool
But with cash earning almost zero now, tactical asset-allocation may call for using alternative assets, such as commodities, for your overweight portion. However, be sure to proceed with caution and do not confuse tactical asset-allocation with pure speculation or absolute market-timing. Therefore it is not wise to allocate more than 10% of your portfolio to an alternative investment type like commodities.

Commodities can also be a good diversification tool because prices are not highly correlated with stock prices. For example, commodities as a whole have had negative returns for three consecutive calendar years, whereas stocks have just finished a five-year positive run, capped by their best year since 1997.

From a contrarian perspective, with rising prices (i.e., inflation) looking more likely in 2014 than in recent years, commodities may be due for a correction in the positive direction. This is because later stages of an economic cycle, as we are arguably in now, are typically marked by higher relative demand for goods and services, and as this demand increases, so does the price of goods and services, which usually causes a rise in prices for commodities used to produce those goods and services.

How to invest in commodities
Investing in commodities need not be complex and should never be too concentrated. For example, it's not wise for most investors to buy commodities futures or to invest in single commodities, such as gold or sugar. Instead, try using a broad commodities index-tracking fund, such as PowerShares DB Commodity Index Tracking Fund (NYSEMKT:DBC) or an exchange-traded note (ETN) such as UBS ETRACS CMCI Total Return ETN (NYSEMKT:UCI).

The PowerShares ETF has a relatively low "tracking error," which means it follows the DB Commodity Index more closely than most other commodities funds. The UBS' product is an ETN that has outperformed the commodity index in recent years. But keep in mind that ETNs combine qualities of ETFs with debt securities (i.e., bonds), which means investors are exposed to both the market risk of ETFs and the default risk of the issuing bank. So, if you want to "keep it simple," you may want to stick with the PowerShares DB Commodity Index Tracking ETF.

So, to bring commodities into your tactical asset-allocation structure, assuming you do not want to overweight cash, you may consider using commodities to complement the stock and bond portion of your portfolio. Following the previous example, in which stocks and bonds were underweight at 60% and 20%, respectively, and cash was overweight at 20%, you might instead reduce your cash holdings to 10% of your portfolio and allocate the remaining 10% to commodities. This would help diversify your portfolio and could also boost your returns in 2014.

No matter what your allocation may be, just remember that the primary consideration for investing decisions is your personal investment goals and risk tolerance, while current economic and market conditions are a distant second consideration.

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