Most people can’t spell commodities, says investing guru Jim Rogers.
ng aside, the idea of putting a percentage of your portfolio in the earth’s resources makes sense, say financial advisors.
Commodities are great for diversification purposes and global demand is rising.
“Commodities are one of the few areas of the world economy that have bullish fundamentals," says Rogers, a popular author and co-founder of the Quantum Fund. "For 25 years there’s been very little investment in production capacity, so we’ve had supply going down at a time when demand is going up.”
As an asset class, commodities have several attributes.
“Principal among them is a pattern of returns which tend to be fairly dissimilar to other asset classes,” says Roger Gibson, founder and Chief Investment Officer of Gibson Capital in Wexford, Pennsylvania.
Such dissimilarities can reduce risk because the ups and downs offset each other. Though not perfectly counter-cyclical to stocks and bonds, commodities are still a fine addition because it is hard to find assets that are negatively correlated. (Slideshow: The 10 Hottest Commodities of 2010)
There are many ways to invest in commodities. The first, buying a commodity outright, involves taking physical delivery, which, excluding gold, is impractical. Besides, what are you going to do with a barrel of oil anyway?
Nearly all investors, Rogers says, would be better off in an an index fund. Gibson also likes commodities index investments because trying to pick an individual commodity relies on skill and tends to cost you more for implementation. If cleverness runs out, you pay for performance that you are not getting.
Gibson uses the Pimco Commodity Real Return Strategy Fund and Credit Suisse Commodity Return Strategy Fund. Both are mutual funds benchmarked to the Dow Jones UBS Commodity Index, and are designed to give continuous exposure to the five basic commodity groups—energy, agriculture, precious metals, industrial metals and livestock.
Another way to get involved is through a futures contract, which is an agreement to buy or sell a commodity down the road at a specific price.
Kevin Kerr, founder of Kerr Trading International in Chicago, actually encourages people who want to put resources into their portfolio to get closest to the actual commodity through options on futures.
The reasoning is that with futures your profits and your risk are unlimited. However, options, on the other hand, allow you to limit your loss and this is what makes them attractive, says Kerr. Rogers agrees that this is the best leverage and way to invest in the commodities themselves, if you know what you are doing. To start the ball rolling on this front, open a brokerage account that allows you to trade futures.
For optimal balance, between 5 and 15 percent of your portfolio should be in resources, adds Kerr. That could include equity resources or related equities, like Deere& Coin the agricultural space. However, he says, investors who are comfortable with equities tend to gravitate towards those related to commodities, and then can’t figure out why they don’t correlate more. The biggest reason is that the actual commodities don’t have the overhead or energy costs that companies do.
To clients who say they don’t need exposure to crude oil because they already own Exxon Mobil , Gibson says, “you get a different investment result from investing in the basic commodity than from owning the stock of companies that are involved in those commodities.”
Exchange traded funds, ETFs, are another way to get in the game.
As of August, there were 52 commodity ETFs with a market value of $83.4 billion, versus 43 and $58.2 billion a year ago, according to the Investment Company Institute. The lion’s share track metals and minerals, specifically gold and silver, with agriculture and energy accounting for lesser numbers.
ETFs, however, can be tricky. Some ETFs are baskets of equities related to the sector, while others are backed by the actual commodity itself.
The two formats will perform differently, and Kerr prefers the latter.
“I’ll get clients calling to say, 'I’m watching gold and it has rallied $300 higher, but my mining stocks are down.'"
Kerr explains that investors are overlooking other factors, such as the price of oil. If oil prices are also going up, it is increasing the production costs of miners because mining is an energy intensive business. If you are considering an ETF, take a long look to make sure it is close to the underlying commodity.
To get cracking on your legwork, Kerr suggests looking online for a source of information that you like and then follow it. Rogers says it is easier research commodities than it is stocks.
“No one knew what a dot com was, yet people were buying them like crazy," says Rogers. "We all know what cotton is. All you have to do is figure out if there is too much or too little of it.”
Bottom line, says Rogers: “If you don’t know anything about commodities, you probably shouldn’t be investing in them at all. If you know a whole lot, focus, concentrate and swing for the fences.”