Commodities: Diversifier and Inflation Hedge or Empty Promise?

Commodities are raw materials and basic products such as wheat, corn, cattle, orange juice, cocoa, coffee, crude oil, natural gas, gasoline, gold, silver, aluminium, copper, zinc and lead. By virtue of being uniform, produced in large quantities, transportable and storable, there exist markets to trade commodities, both at today's (spot) prices and for future delivery (futures). Securities offer an opportunity for an individual to invest in commodities without having to store a pile of coffee beans in the garage and to buy and sell without ever having to take delivery of a shipload of wheat. Commodities are obviously part of the global economy, so what unique qualities do they have that could make them attractive and useful to an investor instead of investing in the companies that produce commodities?
Why invest in commodities?
Two reasons are advanced, which if true, are of significant benefit:

1. Diversification - commodities are negatively correlated to both stocks and bonds, which means that when all are combined in a portfolio, the portfolio will have less volatility and thus less risk. The further away from positive correlation an investment is, the better, and negative correlation is best of all.
2. Inflation protection - in the long run commodity prices track inflation so an investment should help protect an investor's purchasing power.

Risks, Cautions and the Debate

• commodities on their own have enormous and rapid price swings, a very high degree of volatility, which makes them good only for speculation or as part of a portfolio
• the after inflation historical return on individual commodities is more or less zero though return is positive when commodities are combined in a fund
• the inflation protection comes only with a long term investment (more than 10 years) since large short term price swings driven by supply and demand for the commodities mask the effect in a shorter timeframe
  
• some researchers dispute the inflation and diversification benefits - see the Great Commodities Debate on HardAssetsInvestor.com between respected financial authors Rick Ferri and Larry Swedroe. Interestingly, the diversification benefit (negative correlation, i.e. going in the opposite direction) did not always work last autumn during the market crash; in fact, two of the most popular commodities funds (iPath Dow-Jones-UBS Commodity Index Total Return ETN -NYSE: DJP, and iShares Commodity Indexed Trust ETF - NYSE: GSG ) fell harder than the TSX and accentuated rather than reduced the volatility. A third fund, the Elements S&P Commodity Trends Indicator (NYSE: LSC), which employs an active trading strategy, did rise while almost everything else fell. Negative correlation doesn't work all the time.

The place of commodities in a portfolio

• a minor percentage, perhaps 5 to 10% of a portfolio could be devoted to commodities
• replacing a portion of the allocation to each of stocks and bonds
• as a combination in an index fund, though many consider gold an exception worth holding on its own (see previous post on Gold)

How to invest
Though it is possible to buy physical gold, or to buy futures contracts on individual commodities, the easiest and most practical method for a retail investor to get into commodities is to buy index funds - ETFs or their close cousins Exchange Traded Notes (ETNs). Making Sense of Commodity Products on HardAssetsInvestor.com describes the various indexes and their differences, and names common funds based on each index. Stock Encyclopedia list all the currently available Commodity ETF/ETNs in the USA and the handful in Canada. In the list there are many leveraged and even more volatile funds suitable only for speculation so some care should be taken before choosing and investing in anything.
Further Info
HardAssetsInvestor.com has a wealth of primers, background papers and topical information that an investor would be wise to read before making any investment at all.