Commodities have been one of the hottest areas in the financial markets in recent years, but investors need a cool hand to gauge where and when to enter the game.
These days, investors have a wide array of choices in making commodities a part of a diversified portfolio. Choices include futures and options, ETFs, mutual funds, individual stocks of companies involved in the production of a commodity or even buying a piece of the raw material itself, as in the case of gold coins.
“We’ve seen acceptance in the last five years of derivatives as a legitimate and acceptable asset class for retail investors,” says Randy Frederick, director of derivatives at Charles Schwab. “While individual circumstances will vary, you can probably look at 5 percent to 10 percent of a portfolio in commodities.”
ETF Entry Point
For retail investors, one of the easiest ways to access commodities is through exchange-traded funds, or ETFs, especially those providing exposure to a range of different commodities, analysts say. Dabbling in the futures markets is probably best left to the professionals.
“If choosing an ETF, the broad commodities ETF is the way to go for portfolio diversification,” says Karen Dolan, mutual fund analyst at Morningstar Inc. “Given strength in this area it is prudent to invest slowly over time to avoid coming in at the top.”
Investors may have difficulty grappling with the cyclical nature of commodities, with booms occurring every 20 to 40 years or so. As the price of a commodity drops, producers spend less on infrastructure and R&D. When prices rise suddenly, on supply or geopolitical factors say, then capital investment increases to meet demand.
“I certainly think commodities have a role in your portfolio,” says Frank Kinniry, principal, Vanguard Investment Counseling & Research. “But investors need some caution because of their long cycles.”
Analysts are wary of saying that current high prices are close to a peak. Nymex November crude oil has breached $90 a barrel, while Comex gold futures have touched their highest levels since 1980. In any case, they say individual investors usually are not in a good position to react in the moment where commodities are concerned.
Perils Of Futures
“Starting out in the futures market can be fraught with peril,” says George Gero, vice president of global futures at RBC Capital Markets. “Having said that, it’s cheaper to be in futures for the efficiency of money than in an ETF, but the risk is much greater.”
A futures investor need only put up a small portion of the actual value of a contract, but his loss is magnified if the market moves against him. Also, futures contracts must be rolled over, which is an expense. Contracts can’t be kept otherwise an investor has to take or make delivery of the underlying commodity or put up the full money.
Simpler to approach are ETFs because they trade almost exactly like a stock. ETFs are funds which track an underlying index and can be traded throughout the day on major stock exchanges.
“There was big demand from the average retail equity investor to have access to commodities without going to a broker and opening a futures account,” says Frederick at Charles Schwab.
On the other hand,, mutual funds may be more attractive to investors who do not necessarily want to trade actively. “These investors are well served by mutual funds because they have active management,” notes Dolan of Morningstar. ETFs are more index-like and should be low-cost, but Dolan cautions that not all of them are.
Going For Gold
Of all the commodities attracting favor in the past few years, gold may be the one that makes the most sense for the average retail investor and that's all the easier given the variety of gold-oriented mutual funds and the launch of gold ETFs.
George Milling-Stanley, manager of investment and market intelligence at the World Gold Council, says an external study commissioned by the WGC came up with a recommendation for a 2 percent -4 percent strategic long-term allocation to gold in portfolios.
“There’s no bad way to invest in gold,” says Milling-Stanley. “Everyone should have some exposure to the movement in gold prices.”
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