Can Commodities Mount a Comeback?

Barron's MFQ | SATURDAY, JANUARY 7, 2012

By DEBBIE CARLSON

This asset class has had a leading role in many portfolios in recent years, but turned in a dreadful performance late last year. Do these investments merit another audition for a fund portfolio?

Starstruck investors who raced after popular commodities last year discovered how mercurial these markets can be. Big price swings in 2011 left many fans badly disappointed. Even gold, normally viewed as a haven in troubled times, turned in an uneven performance. It rose about 11% if you held it for all of 2011, but that's little comfort to those who bought near its nominal all-time Nymex high of $1,923.70 in September. From that peak, prices ended 2011 down about 19%.

Gold bugs weren't the only investors feeling burned. The Dow Jones-UBS Commodity Index fell 13.37%, dragged down by natural gas (-47.1%), wheat (-34%) and cocoa (-32.4%). There were lots of reasons for the first-half rally's swan-dive, but fears about China's slowing economy as well as Europe's sovereign-debt woes were the most prominent.

So, do commodities deserve another shot? We don't think they should have a starring role in your portfolio early in the year, but they do deserve a supporting part. And investors could have a chance to buy commodity-related funds and stocks at lower prices in coming months if some of the recent global worries persist. In any event, commodities should be included in any portfolio to provide needed diversity.

RESEARCH DONE IN 2005 by professors K. Geert Rouwenhorst and Gary Gorton of the Yale School of Management shows that fully collateralized commodity futures historically offered the same risk-adjusted performance as equities and usually trade in a different direction from both stocks and bonds, offering a good hedge. Despite commodities' short-term volatility, market watchers say rising long-term demand for raw materials from the emerging markets' growing middle class should keep their prices on a general uptrend.

There are different ways to get commodities exposure without having to lug the physical goods home. Much depends on how active or passive an investor wants to be. The traditional way is to trade futures, and they still offer a quick and liquid means of making short-term bets. But futures are strictly for the very active, disciplined trader, says agriculture-commodities advisor Shawn Hackett, president and CEO of Hackett Financial Advisors. "You can't put a futures contract in a drawer and forget about it like you can with an ETF or a stock," he says. Hedge funds and commodity-trading advisors are another alternative, but their investment minimums can put them out of reach of most investors.

MUTUAL AND EXCHANGE-TRADED FUNDS are by far the easiest to understand and can be held for any duration without direct action on the part of the investor. These funds may deal in the futures markets, but the shareholder needn't worry about the intricacies of direct investment or approaching expiration dates.

A broad-based exposure helps reduce volatility and ensures the portfolio benefits from price movements, as commodities don't often affect one another. "Commodities are totally distinguishable," says Abraham Bailin, exchange-traded fund analyst at Morningstar, citing, for example, how Russian wildfires in the summer of 2010 lifted wheat prices, but didn't have any effect on crude oil.

Commodity ETFs offer one way to get wide exposure, though they have received some bad press because of a real issue called negative-roll yield.

The negative-roll yields result from the market's structure, which reflects both the price of current and future supplies. Prices of contracts closest to the present month are usually lower than contracts reflecting what prices could be a year from now. Prices for those longer-dated contracts are usually higher to account for expenses such as the cost of storing and insuring the commodity over time. That higher, future cost is known as carry, or contango.

ETFs based only on nearby prices lose money if a market is in contango because they have to buy the higher-priced, longer-dated contract and sell the cheaper spot month. So they are selling low and buying high. When current prices are above later-dated values, in a condition known as backwardation, the fund benefits by selling high and buying low.

A number of commodity-related ETFs and mutual funds are trying to limit the drag caused by negative-roll yields, say Bailin and Kathryn Young, Morningstar's mutual-fund analyst.

Among commodity ETFs, Bailin likes the PowerShares DB Commodity Index (ticker: DBC), which tracks the Dow Jones-UBS index. Using an algorithm and staying slightly further out on the commodity price curve—three to six months versus the spot price—minimizes the roll yield as prices between these months tend to be more similar.

Bailin also favors the U.S. Commodity Index ETF (USCI), which is based on the research of Yale's Rouwenhorst. Each month the index selects 14 out of 27 commodity futures on the basis of the highest level of backwardation and annual price change. The idea is that higher current prices are forecasting that present supplies on hand will be insufficient to meet future demand and thus make the prospect of higher prices more likely.

Young says the Pimco Commodity Real Return (PCRDX) also follows the DJ-UBS index, but is actively managed to help minimize the effect of roll yield. It has a long, solid track record, and she likes that the fund uses some of its money to invest in several bond funds to lower risk, with much of the cash in inflation-protected securities, known as Tips. Her pure-play commodity mutual fund pick is Pimco CommoditiesPlus Strategy (PCLDX), which tracks the Credit Suisse Commodity Index.

John Person, president of National Futures.com and co-author of the Commodity Trader's Almanac, suggests that retail investors devote anywhere from 5% to 15% of their portfolio to commodities, depending on their risk tolerance. For someone who wants to earmark 15% to resources, he recommends 5% in the SPDR Gold Trust (GLD), 5% in agriculture and 5% in energy, which can be made up of commodity stocks.

In agricultural stocks, he likes meat producers Smithfield (SFD) and Tyson (TSN), noting a drought in livestock-producing areas has cut herds, which should result in higher meat prices in 2012.

To reach his proposed allocation in energy, Person favors Market Vectors Oil Services ETF (OIH) as a way to buy the oil-services index. Because oil prices already are high, there's substantial demand for more productivity, which should bolster the group, he says. If natural-gas prices continue to fall, the U.S. Natural Gas Fund ETF (UNG) could be a good value, especially if the natural-gas futures contract falls near $2.80 per million BTUs, where he would buy "aggressively." More coal-fired power plants are switching to gas because of new Environmental Protection Agency rules.

Keep in mind that buying commodity stocks isn't the same thing as owning the actual commodity. At the very least, commodity stocks are going to be more influenced by the equity market and may not reflect the short-term circumstances within the physical market, say Bailin and Person. For instance, gold mining stocks have at various times in recent years far outperformed the price of gold because their profitability improves very sharply once they reach breakeven.

Agriculture-commodities advisor Hackett says hard assets can have a place in a retail portfolio, but only if the investor understands the high risk/high volatility nature of commodities. "The job as an investor, as a user, as a producer is to know when to sell and when to buy." He dislikes commodity ETFs, suggesting instead that investors target agriculture companies with production and infrastructure capacity. He likes Cresud (CRESY), a South American farmland trust, and Alliance Grain Traders (AGT.Canada), a Canadian agriculture firm.

Cresud makes it easy for someone to own farmland without having to buy actual dirt, while he sees Alliance Grain Traders as a strong niche player in the "pulses" market—protein crops like lentils and chickpeas. It's a way to play the growing global demand for food. "These crops are too small for the big ag firms to care about, and the firm knows the buy and sell sides of the business," Hackett says.

MANY ADVISORS CAUTION against jumping into commodities in a big way until the conditions that caused the drop in late 2011, like Europe's debt problems, begin to subside. And some markets, like cotton, sugar and cocoa, are still suffering from oversupply. As Hackett puts it, "Now is a good time to get ready to buy as the trends are down."

The second half looks more promising as an entry point, since prices could come down a little further and commodities often herald an economic rebound, possibly in 2013. That would put commodities back on center stage.