If you investigate the returns of single assets like stocks, bonds, and real estate, you’ll find that they are generally not highly correlated with commodities. Therefore, by adding commodities to your portfolio, you diversify it and decrease the likelihood that the value of all your holdings will decline simultaneously. This is great news when stocks are volatile and on the decline. It also makes a lot of sense: Commodities represent another “basket” and you diversify by not putting “all your eggs in one basket.” If you’re an investment guru, like Warren Buffett, then you don’t need to worry about this. For everyone else, diversification is simply a requirement. Due to the fact that not all assets zigzag in unison, it protects your portfolio from the inevitable market crashes.
It used to be challenging to participate in the commodity market. You either needed to be a high net worth individual (because of the large minimum investment required to set up an account), or you needed to be familiar and comfortable with trading commodity futures. This is no longer necessary. Any retail investor can now allocate part of their portfolio to commodities by buying a commodity ETF. These publicly traded securities can be traded on a stock exchange and are available through regular brokerage accounts. They are traded intraday and are bought and sold in the same way as stocks.
There are now over a hundred different commodity ETFs, so how do you decide which one to buy? For most investors, it makes more sense to buy a broad commodity index fund. A widely followed commodity index is the S&P Goldman Sachs Commodity Index (GSCI), which tracks 24 different commodity futures contracts. With this one investment, you can track the price of all the most common physical products in the world.
When held as a diversified basket, commodities typically have lower volatility than other risky asset classes, such as stocks. For example, during the global financial crisis just a few years ago, stocks were more than twice as volatile as the S&P GSCI Commodity Index. A commodity ETF is an unleveraged way to profit from rising commodity prices. This is very different from trading commodity futures contracts, which involves a lot of leverage: a moderate change in the price of the underlying commodity can liquidate your account. This makes commodity ETFs much more suitable for a typical investor.
Apart from individual investors, who else invests in commodities? Hedge funds are very active in this market, as are pensions and insurers. Even university endowments participate. For example, did you know that the Yale University endowment requires that more than twenty percent of its investments go into commodities? And Yale is no exception, many other university endowments invest in commodities or similar real assets, such as timber forests.
There is something to be said about “following the smart money.” There is no reason why a normal investor should not have an allocation to commodities. They nicely complement the stocks and bonds that form the mainstay of most investment portfolios. I wouldn’t be surprised if in another decade or two, commodity investing is as normal as bonds and stocks.
Although commodity ETFs have become popular in recent years, some investment experts still advise against investing in this market. The common criticism is that commodities do not grant ownership of something that has inherent value, unlike, say, a stock, which represents actual ownership of a potentially growing company. Noted investment author and portfolio manager William Bernstein has compared commodity investing to “picking nickels in front of a steamroller.” In his words, “the risk of being crushed is enormous.” Another well-known writer and adviser, Rick Ferri, also disparages them, saying you should stick with tried-and-true stocks and bonds instead.
In short, it may be worth adding a commodity ETF to your investments, if you haven’t already. But don’t just take my word for it. Do your own homework before making any investment!