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The Importance Of Commodities In A Portfolio

 

What Are Commodities?:

 

Although it may sound frightening and risky to many investors, if handled correctly, commodities could be the missing integral piece of an investor’s portfolio puzzle.  What exactly are commodities?  Commodities are any mass goods traded on an exchange or in a cash market including: cocoa, coffee, eggs, lumber, orange juice, soybeans and sugar just to name a few. Industrial metals are also included with copper, aluminum, zinc, nickel, silver, and lead ranking among the most popular industrial metals holdings.  They are traded in order to profit from the fluctuation in price from these basic goods.  These potential profits result from the buying or selling of futures contracts in a particular good.  A commodities futures contract is an obligation to purchase a commodity at a given price and time.  For instance, an investor could purchase a contract, which obligates him to buy sugar in June at a stated price.  Money is made when the price of sugar rises, thus increasing the demand of that contract because it allows the investor to purchase sugar at a lower price.  If this sounds complicated, it is.  Investing in the commodities market should rarely be done by an individual investor, and should instead be left to a Commodities Trading Advisor (CTA), a Commodity Pool Operator (CPO) or perhaps even a mutual fund that invests in a commodity index.  In any case, a competent financial advisor should also see commodity investing.  Commodities are traded on an exchange or in a cash market.  The Chicago Board of Trade (CBOT), the Chicago Mercantile Exchange (CME), and the London Mercantile Exchange (LME) are among the most popular futures exchanges. 

 

Rewards:

 

The diversification benefits equal or surpass those of other asset classes like fixed income and real estate.  The primary reason for this is their correlation, or lack thereof, to the stock market as represented by the S&P 500 (Correlation describes how similar the price movement is between two investments).  Commodities have historically exhibited absolutely no correlation whatsoever to the stock market or any of the bond market indices.  In fact, they have a negative correlation.  This non-similar pattern of performance allows an investor to minimize volatility and protect capital in down markets.  Overall, these factors help to decrease overall risk in a portfolio of investments.

 

Risks:

 

When commodities are utilized as a stand-alone investment, commodities are relatively volatile, exhibiting wild price swings.  At times, they are also illiquid, prohibiting the investor from exiting a position that is dropping rapidly.  Another factor to be aware of when investing in commodities is the unusual income taxation.  Most notably, investors are taxed each year on their share of the profits, if there are profits, regardless of whether the investment has been sold.  This is a significant disadvantage compared to investments in stocks, because one does not pay income taxes until the stock is actually sold.  Also, in the event an investor invests in a commodity pool or partnership, it is very possible to owe income tax on interest income from the fund, even though the index may have had a down year.  Finally, fees to implement a commodities strategy are significantly higher than for those of mutual funds, for example.  For these reasons, it is best to reserve only a minor portion (15.0% or less) of one’s portfolio for this strategy.

 

Why Commodity Investing Is Important Now:

 

This is not to say that this asset class has not earned a spot in a well-diversified portfolio.  It has.  According to investment legends such as Warren Buffet, Bill Gross of PIMCO, and Jeremy Grantham of Grantham, Mayer, and Van Otterloo, equities are expected to return no more than 5% over the next decade because of their currently lofty valuations.  With commodities being inexpensively priced, substantial upside potential is possible.  U.S. inflation is historically low right now but with the effects of massive fiscal and monetary policy colliding with expected interest rate increases and already robust consumer spending, undoubtedly raw goods prices will inevitably increase.  When they do, commodity indices will no doubt follow suit.  As inflation gradually rises in 2004 and 2005, industrial metals prices will rise as investors begin to direct large amounts of money into these hard asset commodities.  The high correlation between commodities and inflation provide an important hedge against considerable losses in traditional financial instruments such as stocks and bonds. 

 

Commodities also provide a tactical play on the current weakness in the Dollar.  As other currencies such as the Euro and Yen appreciate versus the dollar, foreign buyers can buy fewer goods with the same amount of currency.  This artificially increases demand, and subsequently drives up the prices of commodities.  Currently, effects of this phenomenon can be seen best in the gold and silver markets as prices have risen dramatically over the past year. 

 

Commodities provide a play on globalization by their ability to aid in the improvement of the global economy.  This is due to the fact that prices for industrial materials will increase as demand for industrial goods increase.  As countries such as China and other emerging market economies develop, they will require more raw staples.  This is especially true for industrial metals.  China continues to develop at a rapid pace and consequently, their demand for raw materials continues to rise.  In fact, China’s iron ore demand has increased from 5% of the world’s supply to almost 50% over the past twelve years.

 

Conclusion:

 

Commodities are excellent investment opportunities at present.  There are a number of types of investment vehicles to take advantage of this great diversification play.  U.S. stocks and bonds will, in all likelihood, generate significantly lower returns than in the past over the next decade.  Commodities on the other hand have the potential for the highest returns since the 1970s due to a worldwide economic expansion especially from emerging market countries.

 



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