Getting to grips with commodities

We've written over the last few weeks about the most common asset classes available to investors shares and bonds. Until quite recently, that was all most people felt they needed. The general consensus was that you invested in a mix of the two based on your age: the older you were, the less risk you wanted to take, and the higher a percentage of bonds you held in your portfolio.

Then in the 1980s professional investors started paying attention to the success of those who branched out a bit, such as David Swensen, who took over as chief investment officer at Yale University in 1985. Swensen's Yale Model appeared to offer consistently high returns: in the ten years to 2009 he made a good 11% a year. How? By diversifying into different asset classes and particularly into "real" assets that are harder to buy and sell than stocks and bonds (which you can trade on an exchange in a second). Assets such as energy, timber and property.

These days everyone wants to see if they can diversify to improve their returns and everyone is looking to buy into a variety of asset classes to help make that happen. Commodities are the obvious place for ordinary investors to start looking once they have got to grips with shares and bonds.

What counts as a commodity?

Pretty much anything that is tangible oil, pigs, copper, wheat, for example and interchangeable (one unit of it is all but identical to another unit of it). The market is divided into two parts hard commodities (basically things that are dug up, such as metals, oil and even water) and soft commodities (things that are grown, such as fruits, grains and livestock).

Investing in any of them directly is simply a matter of betting on rising prices. However, that isn't particularly easy to do. Not many of us can buy a whole forest, take delivery of a million barrels of oil, or take care of a few thousand sheep. So we either have to bet on the prices themselves via one instrument or another, invest via commodity funds, or simply buy the shares of companies that trade, mine, or grow commodities of some kind.

The latter is straightforward the big mining companies and oil companies clearly make more money when commodity prices are high than when they are low. So if you buy a well-managed miner at the right price when you expect commodity prices to rise and they do, you'll make money too. The same goes for oil companies.

The other way to look at the corporate sector is to buy into the firms that service the commodity sector. So if you are expecting rising food prices and hence attempts by farmers to increase their yields, it might be worth investing in fertiliser or tractor companies. Equity-based commodity funds are also pretty simple. Invest in BlackRock World Mining or the City Natural Resources investment trust, for example, and you will end up with a good spread of commodity-related investments.

Going passive

You can also look at passive funds exchange-traded funds (ETF) that simply track the price of a basket of assets. You can buy ones that track the prices of a group of commodity companies, such as the Market Vectors Gold Mining ETF (which tracks the price of large gold-mining companies), but also ones that simply track the price of a basket of commodities, or one commodity in particular (lots of MoneyWeek readers hold the London-listed ETFS Physical Gold ETF, for example).

If you are planning on doing the latter, and you want to keep it simple, look for exchange-traded products that are physically backed if available ie, that actually hold the commodity in question and that track the spot price (the current price) of the commodity rather than the futures price. ETFs that track commodity prices are known as exchange-traded commodities (ETCs).

Why bother?

Investing in commodities isn't necessarily a good thing to do. The companies pay dividends, but the commodities themselves clearly don't and in the long term, an awful lot of people have lost money in this market.

On the plus side, commodity prices often move in the opposite direction to equity prices (they have a low correlation with equity prices), something that might reduce the overall volatility of a portfolio. Commodities also have a history of working well to protect investors against inflation: they rise as the general price level does.