Commodities Investing: Choices & Challenges

Brother #1: “Mother always said you were greedy.”

Brother #2: “She meant it as a compliment.”

—From the movie, Trading Places

Trading Places, the hit 1983 film starring Eddie Murphy, provides an entertaining view into the world of commodities, a realm then known only to masters of the universe. While using Eddie Murphy’s character as a would-be straw man, two high-rolling brothers played by Don Ameche and Ralph Bellamy made millions trading pork belly futures and other commodities contracts before getting their comeuppance.

Since then, the advent of commodity funds brought world to retail investors, albeit on a much smaller scale. Subsequently, exchange-traded funds have made investing in commodities even more accessible to retail investors. “Both are good ways to invest in commodities, and each has advantages and disadvantages,” explains Jeffrey Ptak, Morningstar’s director of exchange-traded securities analysis.

Now that these products are in place, more and more retail investors have been positioning to attempt to profit from increasing activity in commodities markets.

Fed by Grain Boom

Agricultural commodities have been booming in recent years. Increasing global consumption and critical droughts have pushed wheat prices up multifold, topped by a 50% increase between August 2007 and February 2008. Corn, soybeans and sugar prices have also been rising abruptly. So trading in futures contracts and other derivatives based on them—and for other food items like cattle—has also been brisk.

A ceaseless construction boom in China continues to fuel demand for mineral commodities such as aluminum ore, iron ore and copper. Meanwhile, the price of precious metals has been heavenly of late, and the ascendance of crude oil and natural gas prices has been sustained by global demand and reports of limited reserves.

Despite the boom commodities investing is no slam dunk. Even amid scenarios of increasing global demand are fraught with factors that can result in slowdowns, lulls and halting investment. Hence, as in most investments, there’s volatility and as in all investments, there’s risk.

Yet studies including those done at Columbia University and Brigham Young University have shown that properly handled commodities-based investments in the right measure can reduce overall portfolio risk, including interest-rate exposure.

But commodities require a different mindset than stocks. Experts stress that commodities investing is fundamentally different than stocks in one critical aspect: On average, the longer investors hold diversified stock portfolios, the more assured they are of reaping returns. This isn’t necessarily the case with commodity-linked investments.

So physician-investors should be especially careful not to purchase commodity-based products just because commodity prices are rising, says Bill Miller, a respected Legg Mason fund manager. This practice can be punished in the stock market because commodities investments haven’t historically produced the long-term growth typical of properly diversified stock portfolios, which tend to make up for ill-timed purchases over the time.

The Fee’s the Thing

For those without the resources of the characters in Trading Places, the inherent risks of the commodities markets can be homogenized by commodity funds. These funds offer individual investors diversification in different commodities, thus balancing the risk of one commodity with the potential success another. Yet for these returns, investors can pay high fees, often in the neighborhood of 1.25% (1.24% for PIMCO Commodity Real Return).

To offset the disadvantage of these high fees, experts say, investors typically must have a substantial investment in commodity funds—an investment that may exceed the total amount permitted by the asset allocation plan of even wealthy individual investors such as physicians advanced in their practices.

For those doctors whose asset allocation plans deem this heavy investment lopsided, or those biased against high fees on principal, exchange-traded funds (ETFs) may be a more suitable way to invest in commodities. ETFs reflect the performance of indexes, commodity indexes among them, and, like commodities themselves, are traded on exchanges.

Yet fees on ETFs are on average far lower than actively managed commodity funds; many respectable commodity-based ETFs charge .75% (75 basis points), as does IPATH Crude Oil. (Returns and prices on ETFs and commodity funds can be tracked on web sites including MSN Money and MarketWatch.)

Like many commodity funds, some ETFs are diversified and track multiple indexes. So busy physicians can add these to their investment portfolios without having to worry about the weather’s impact on the price of frozen orange juice.

Surgery: Not for the Faint Hearted

Some experts are critical of the rising costs of some previously passively managed ETFs, which have added active management and, consequently, higher fees to new yet innovative products. Some of these track small market niches, thus sacrificing diversification, while others are making investments with borrowed money, which increases costs.

Yet Morningstar’s Ptak says this fee creep isn’t pervasive. Adds Gary Gordon, a certified financial planner and president of Pacific Park Financial: “ETFs, still offer the low cost of index mutual funds and high flexibility in trading.”

Another advantage to using ETFs for commodity investing is the flexibility to adjust the level of exposure to individual commodities. “You can dial in your exposure to specific commodities surgically,” says Ptak. “If you want to invest more within a given ETF in crude oil or natural gas, for example, than is offered off the shelf, you can change this. Of course, this option isn’t for the faint of heart.”

Fee-conscious investors with the stomach for making investments based on individual commodities may want to talk look at exchange-traded notes. Like ETFs, ETNs are traded on exchanges. Yet, instead of being based on futures contracts, they basically function as bonds representing an obligation to repay the initial investment plus the index’s return (after the management fee is taken out).

ETN fees of 75 basis points aren’t uncommon, but there are some less expensive varieties underlain by precious metals (gold or silver) that carry fees of only around 40 basis points. Yet along with these low fees on these less diversified investments comes added risk. Cautions Ptak: “The average retail investor should be careful and not go willy-nilly into something are tricky as precious metals. This is not easily navigated terrain.”

Financial writer Richard Bierck is a former contributing editor for Bloomberg.