Alternative Investing

Commodities can be a portfolio hedge

Maggie Overfelt, Special to
Anthony Bradshaw | Photodisc | Getty Images

The most unsettling thing about commodities investments—their inherent risk—is also their best feature as an alternative investment strategy, financial advisors say.

Because the performance of commodities does not correlate with that of equities or fixed income, allocating a small percentage of a portfolio to natural resources can actually lower the overall risk in the long term, said Patrick Robert, co-founder and CEO of PKR Investments, a financial consulting firm.

"For people who want [their portfolios] to be diversified, if they're not hitting a home run right out of the gate [with equities], commodities can act as a hedge," said Robert, who is also a certified financial planner.

Unlike stocks—which are somewhat easier to valuate because investors can examine data such as a company's financial metrics and growth plans—the value of commodities is largely unknown.

(Read more: Investors have 'alternative' options)

"When you talk about the value of gold or silver, it's based solely on supply and demand, which is difficult to determine," Robert said.

The recession in the U.S., a weak outlook for growth in Europe and excess supply have all contributed to a broad commodities selloff over the past 12 to 18 months.

But experts say as the global economy improves, investors should begin to warm again to commodities. This is especially true of growth-oriented assets such as the base metals—like aluminum, copper and tin—that are used in emerging markets and places where manufacturing is ticking up, as in China.

"Commodities are a tough place to be right now, a phenomenon that we've seen over the last year or so," said Dave Molnar, a managing director at HighTower Advisors, citing an expected rise in domestic and global economic growth rates that hasn't yet materialized.

"With the outlook of the quantitative-easing potential, we could see a high level of inflation in the future," he said. "If we get that environment, then commodities will reignite and provide a nice hedge."

Now is a good time to enter into commodities, given their slow upward creep, financial advisors say.

But experts warn that investors should wait until things are clearly on an upswing before increasing their positions.

"Commodities are cheap right now, relative to other assets," Molnar said. "But we're still lacking the catalyst: better growth figures from our economy. That's the trigger point to start increasing positions."

Some financial experts did point out that natural gas futures have plunged more than 2 percent in heavy volume to the lowest price in more than five weeks, hitting a session low of $3.406. Forecasts for above-normal temperatures and limited heating demands across much of the country in the coming weeks are depressing the natural gas market.

"A lack of early cold, in combination with near if not new record highs in dry gas production, plus more than ample supplies of gas in storage have dragged prices back to within a penny of September's prompt gas contract low at $3.400," according to analysts at Tradition Energy. "But the fast-approaching start of winter and increasing levels of coal-to-gas switching as power generators ramp up their gas-fired power plants to take advantage of low gas prices should provide support for the market."

(Read more: Alternative strategies for 'average' investors)

Experts recommend buying into a broad-based exchange-traded fund (ETF) or exchange-traded note (ETN) rather than focusing on one particular commodity or market.

While an ETF is a relatively low-cost fund with stock-like features that gives investors exposure to a range of commodities, an ETN is a debt security issued by an underwriting bank.

"Because you're taking on the risk of the actual issuer [of an ETN], an ETF is less risky," said Durraj Tase, founder and chief investment officer of DT Investments.

When choosing a commodities-based ETF, investors should stay "broad and basic," said Jonathan Citrin, founder and executive chairman of CitrinGroup, an investment advisory firm. "The great amount of growth comes from the [commodities] you don't see, the smaller ones that the average investor wouldn't be likely to invest in."

Advisors like ETFs, such as the PowerShares DB Commodity Index Tracking Fund (DBC), that track an underlying index. According to Robert: "these tend to be very diversified and will give investors the broad-based exposure they are looking to achieve while being charged reasonable fees, around 0.85 percent."

While many ETFs are weighted heavily toward one sector, DBC, for example, provides exposure to more than a dozen commodities from different sectors, including corn, wheat, copper and heating oil.

(Read more: Senate peeks inside bank commodities)

When dealing with ETFs, investors should keep in mind that most of them invest in futures contracts rather than exposure to the commodity's spot price, advisors say.

Therefore, Molnar said, "the slope of the underlying futures curve will play a role in the overall return of the fund, even if the spot price remains unchanged."

A futures contract, or agreement to buy or sell a commodity later on at a specific price, is itself another entry point into natural-resources investment.

However, advisors caution that futures and options contracts should only be used by experienced investors. With futures, buyers and sellers are not only trading at the mercy of volatile commodity prices; they also need significant resources to open brokerage accounts allowing them to access the market.

For a favorable balance over the long term, most advisors say that 5 percent to 10 percent of a portfolio should be allotted to commodities.

(Read more: It's time to rebalance your portfolio)

The more bullish among them, however, may advise going up to 25 percent. While many steer clients toward ETFs, investing in related equities—for example, metal mining stocks such as Barrick Gold (ABX) or Newmont Mining (NEM)—can give investors a different type of exposure to resources while adding potential dividend income.

The bottom line is that commodities aren't for everyone. They can, however, provide an important hedge during future inflationary periods.

"On the whole, we've found that commodities have been useful in portfolios no matter what the market has seen," said Martin Kremenstein, Deutsche Asset & Wealth Management Americas head of passive management. "They can offer volatility and diversification benefits, and there's a place for them in a portfolio alongside equities and fixed income."

—By Maggie Overfelt, Special to