How to Approach Commodities

Physician's Money Digest, August 2005, Volume 12, Issue 12

Traditionally, the average physician-investor doesn't delve intothe world of commodity investing.Either they're not sure justwhat commodities are, or they don't considerthem a viable investment. However,adding commodities to an overall portfoliomay be a prudent investment decision.

Commodities Rundown

Commodities are the raw materialsthat producers use to create the goodspeople buy and the food that they eat.These materials include energy (eg, oiland gasoline), metals (eg, gold and aluminum),and agriculture (eg, wheat, cattle,and orange juice). Because commoditiesare distinct from financial assets suchas stocks and bonds, they react differentlyto changing economic conditions andthus add diversification to a portfolio.This can be especially appealing when thestock and bond market is volatile andthere is a resurgence of inflation.

In a diversified portfolio, the goal is tohave assets that do not move in sync witheach other, thus helping to limit thevolatility of the overall portfolio. Becauseof its potential to reduce risk whileimproving returns at the same time, diversificationis often referred to as the only"free lunch" in investing, although thereis no assurance that a diversified portfoliowill outperform a nondiversified portfolio.Many studies have demonstrated thatstocks and commodities often move in anuncorrelated manner.

Commodities Growth

Barry Bannister of Legg MasonEquity Research suggests growth ratesof commodity prices and consumerprices historically have outpaced oneanother in alternating cycles lastingmore than a decade. The historicallynegative correlation between commoditiesand stocks was demonstrated overthe past 5 years ending Dec. 31, 2004.During that 5-year time frame the S&P500 index was down 1.77%, while theDow Jones AIG Commodity Indexreturned a positive 8.68%.

Bannister is also optimistic about thegrowth potential of commodities, a viewwhich many industry experts share.Others cite the main reason for thispotential growth in commodities is basicsupply and demand economics. In thisregard, there is huge demand around theglobe for basic raw materials. The industrializationof emerging economies, suchas China and India, is causing increasedcompetition for commodities with thedeveloped countries. The result is thatdemand is exploding at the same timesupplies are diminishing.

Many experts believe that this hugedemand for infrastructure could meanthat we are in the early stages of a long-termupward cycle for commoditieswhich could go another 10 or more years.This is because there is a significant lagtime between the initial demand andactually producing the needed raw materials.This long cycle is consistent withpast commodity cycles, as demonstratedin Bannister's study.

Access to Commodities

Despite these potential benefits, commoditieshave typically played a smallrole in portfolios of the average physician-investor for a couple of reasons. Thetaking of physical commodities, such as aherd of cattle in your backyard, is notexactly practical. Also, futures'contractsare inappropriate for most investorsbecause they are complex and often arepurchased using high amounts of leverage.However, these barriers are beingovercome by mutual funds offered byPIMCO, Oppenheimer, and MerrillLynch, therefore providing investors withgreater access. These firms have commodityfunds available to all investors atlow minimums and offer a highly competitivecost structure.

The PIMCO Commodity RealReturn Strategy fund is the moststraightforward commodity mutualfund, as it simply invests in financialinstruments that seek to replicate theperformance of the Dow Jones-AIGCommodity Index. The Dow Jones-AIGCommodity Index tracks the futuresprice of 20 different commodities,including energy, livestock, grains,industrial metals, precious metals, andsoft commodities. As a result, commodityindex returns provide passive exposureto a broad range of commodities.

One advantage of broad index commodityexposure is that commodities arenot highly correlated with each otherand an index return should be lessvolatile than the returns on an individualcommodity. Another advantage is thatcommodity indexes themselves existedfor decades, providing ample historicaldata for asset allocation studies andresearch. Conversely, Oppenheimer andMerrill Lynch invest in commodityfutures contracts as well as commodity-relatedstocks. This approach offers thepotential for greater reward, but alsocan entail greater risk.

Should you consider investing in commodities,keep in mind that they haveshown greater short-term volatility thanstocks. Furthermore, commodities fundscan incur significant taxable distributions,so you may want to hold them in anontaxable account. Based on the benefitscommodities offer in achieving portfoliodiversification, along with the accessavailable to commodities through mutualfunds, now may be a good time to considerthis asset class as a valuable additionto your overall portfolio.

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John P. Ciccone