Key Considerations When Adding Commodities To Your Portfolio

The Russian invasion of Ukraine and the resulting sanctions have put commodities into focus. U.S. wheat futures reached a record high last week. So did nickel. (The metal in that five-cent coin in your pocket was worth more than five cents.) Gold is nearing its record high. Oil prices are above $100 per barrel.

Commodities are prone to big price moves in both directions. Even with their volatility, there can be a benefit to holding them as part of a diversified portfolio. How you get exposure to them matters, though.

Rising commodity prices are a frequent element of higher inflation—as anyone who has been to a gas station lately well knows. This characteristic makes commodities a hedge against inflation. A study published in the December 2010 AAII Journal found a 5% to 15% allocation to commodities improved returns compared to an otherwise all-stock portfolio during periods of restrictive monetary policy. The study looked at the time period of December 1970 to August 2007.

AAII contributing editor Craig Israelsen found that commodities realized an average return of 22.0% during years with above-average inflation. The trade-off for this outperformance was an average loss of 1.9% during years when inflation was below average. Israelsen looked at the period of 1970 through 2015.

Unlike stocks or bonds, commodities are physical assets. You can buy precious metals and store them as you like. You’re not going to store barrels of oil or bushels of wheat.

Most individual investors will get exposure to commodities either through exchange-traded funds (ETFs) or exchange-traded notes (ETNs) or through shares of commodities-related companies. It is also possible to trade futures directly, though this entails more risk and complexity.

I cannot stress enough the importance of looking what a commodities-focused ETF or ETN actually invests in before buying it. Gold provides a simple example. SPDR Gold Shares (GLD) invests in a trust that holds gold bullion. Conversely, iPath Gold ETN (GBUG) provides exposure to a rolling position in gold futures contracts. SPDR Gold gained 4.9% during the first two months of 2022 while iPath Gold gained 3.9%.

Whenever futures contracts are involved, expiration is an issue. A fund manager will need to roll the contracts forward, meaning switch to new contracts with later expiration dates, at regular intervals. How they do so and the costs they incur when swapping out contracts will impact their returns.

While SPDR Gold and iPath Gold are very specific, there are several ETFs and ETNs targeting a broad basket of commodities. These give you broader diversification, but allocation matters. Having different weightings to agriculture, energy and precious metals will result in different returns. Plus, the weightings are not static for every ETN or ETF, adding an additional wrinkle.

None of this means commodity-focused ETFs and ETNs should be avoided, but rather means you should look at the investment’s factsheet and prospectus before buying it.

Commodity-related stocks come with both business risks and valuation considerations. A gold mining company will own gold mines as well as equipment. The company also incurs the operational challenges of operating those mines. Agricultural-focused companies like Deere & Co. (DE) and Mosaic Co. (MOS) are exposed to the health of the farm economy. Plus, all commodity stocks are impacted by the overall state of the financial markets.

Buying precious metals comes with its own challenges and risks. Secure storage is a big one. Transaction costs and the ability to buy and sell at the spot price are another. Scams, such as those involving precious metal coins, are also a problem. Of course, unlike oil or wheat, you can wear your gold.

The decision of whether to include an exposure to commodities in a diversified portfolio is an optional one. Individual investors can achieve much success by simply finding the appropriate mix of stocks, bonds and cash and sticking to that allocation over the long term. Adding in commodities can provide additional benefits, but prudence and a disciplined approach are required.

____

If you want an edge throughout this market volatility, become an AAII member.