Commodity Funds Volatile But Offer Hedge

Q. I’ve read that a mutual fund containing commodities will help give my portfolio some diversification and help me make money when the stock market is down. I have heard of Pimco Commodity Real Return. Are there other commodity funds? My financial consultant was having difficulty identifying them.
–D.B., Baltimore

A. Some research suggests commodities should be part of a portfolio because they respond to economic factors differently than stocks or bonds. So, for example, when stocks are falling due to inflation concerns, commodities–everything from oil and copper to corn–might rise and smooth out the pain from stocks.
That’s just the tendency, however. You can’t always count on commodities to work that way. Since early May, investors have been getting hurt in stocks and commodities. And bonds have been losers too. Only money-market funds and bear-market funds have been moneymakers.
Also, although commodities historically have helped investors when stocks or bonds dropped, they also can scare investors.
Commodities are significantly more volatile than the Standard & Poor’s 500 stock market index, said Ibbotson Associates research director Thomas Idzorek, who recently evaluated 35 years of market history for a report commissioned by money management company Pimco.
For a sense of the scare commodities can deliver, consider 1998: Commodities plunged 27 percent.
“Ask yourself if you would truly hold onto that commodities investment if commodities prices swooned over the next few years,” said Morningstar analyst Karen Wallace.
Recently, investors have had a taste of commodity volatility. It follows three outstanding years in which the Oppenheimer Real Asset Fund, based on the popular Goldman Sachs Commodity Index, averaged a 22 percent annual return.
Copper alone jumped about 80 percent. Gold surged to a 26-year high after being distasteful to investors since the ’80s. But as analysts became increasingly vocal and worried about speculation in commodities, the trend reversed in May. Copper lost 24 percent, and gold 20 percent.
The Pimco Commodity Real Return fund, based on the Dow Jones AIG Commodity Index of 19 commodities, lost 5.7 percent in June. The commodity index fund dropped roughly 5 percentage points more than the S&P 500 index, according to Morningstar.
Given that reality check, investors are in a better position to evaluate their desire for commodities than earlier this year. Then, pension consultants and financial advisers were telling clients to add commodities to diversify portfolios, but it wasn’t clear whether the motivation was truly diversification or chasing a hot investment.
During the last few weeks, the hype over commodities has died down and turned into caution.
Pension consultant Mercer Investment Consulting warned pension funds last week about investing in commodity futures, which is the common approach used by mutual funds and exchange-traded funds.
Andy Green, European director of investment policy at Mercer, noted that commodity futures prices recently have been above spot prices for the commodities. It’s a somewhat unusual condition called “contango,” and some analysts believe it might be a result of speculation. Green said the pricing creates a drag on the Goldman Sachs Commodity Index.
With investors jittery about stocks and commodities, making your first move into commodities now could end up being nerve-wracking.
Still, based on research by Ibbotson Associates, Wallace sees a valid reason to slowly put some money into commodities, if you have the stomach for it.
Idzorek found that during the eight years in his 35-year study when stocks were losers, commodities had their highest return: 9 percent on average a year compared with a 12.2 percent annual loss in stocks during those periods. In the seven years when a portfolio divided 50-50 between stocks and bonds had losses, commodities also were positive, averaging 16.4 percent. And during the two years when bonds lost, commodities were winners, up 20.9 percent.
Returns in commodities vary, depending on what index is used to measure returns. Idzorek noted that from January 1991 to October 2005, the Dow Jones AIG Commodity Index provided an average annual return of 7.6 percent, while the Goldman Sachs index, which is highly dependent on oil, had a 12.4 percent average annual return from 1970 to October 2005.
By comparison, the stock market, using the Dow Jones Wilshire 5000 index, provided an average annual return of 11.36 percent during a similar period beginning in 1971.
If you decide to invest in commodities, consider dollar-cost averaging, or adding small amounts of money weekly, monthly or quarterly. And don’t exceed 5 percent to 10 percent of a portfolio, Wallace said.
She suggests the Pimco Commodity Real Return (PCRDX) fund, which is more diverse because it is less dependent on oil than the Oppenheimer Real Asset Fund (QRAAX).
The funds aren’t purely invested in commodities. Bonds also are used.
People who wish to trade in and out of commodities quickly might prefer a commodity exchange-traded fund. The first one of probably many to come is the Deutsche Bank Commodity Index (DBC). Rather than investing in a broad range of commodities, however, it selects only sweet light crude oil, heating oil, aluminum, gold, wheat and corn.
Wallace finds two other products interesting but too new to recommend: the iPath GSCI Total Return Index (GSP) and the iPath Dow Jones-AIG Commodity Index Total Return (DJP). Both are based on broad commodity indexes and trade like exchange-traded funds on the New York Stock Exchange. But they are structured notes, or 30-year debt securities tied to the indexes, Wallace said.
They are convenient to trade, have lower fees than the mutual funds or Deutsche Bank product and appear to be less likely to result in capital gains taxes for investors, Wallace said.
But she cautioned to watch their track record for a while rather than jumping in.

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