Speculating on commodities can add diversity to your portfolio

Anyone with an equity fund that tracks the S&P 500 has something close to 10 per cent of their investment in commodities companies, such as oil and gas producers or the miners of metals and minerals. For anyone who owns the FTSE 100, the figure is more than 20 per cent, largely because BP and Shell dominate the UK stock market.

Yet an increasing number of financial advisers suggest that investors should also carve out an additional piece of their portfolio to invest directly in commodities.

The advice is controversial but for many people who are considering moving beyond a “plain vanilla” portfolio of stocks and bonds, commodities will be an obvious option to consider.

The list of tradeable commodities literally runs from A to Z, from aluminium to zinc. Crude oil and natural gas are among the most important to the global economy, but energy investors can also pick propane or ethanol or heating oil. Agricultural staples include corn and coffee and cocoa, among many more. And there are a good half-dozen industrial metals to trade, and precious ones, too, including the speculator’s favourite: gold.

Just about the only characteristic in common across this diverse list is volatility. Commodities do not pay dividends or generate earnings like company shares and they do not promise to pay interest like a bond. Without these anchors, their price swings wildly in response to changing assumptions about supply and demand.

As a reminder, the price of a barrel of crude oil plunged by 50 per cent in the space of a few months in 2014 after a subtle change of policy in Saudi Arabia, one of the world’s largest oil producing nations.

Political developments are far from the only things an investor has to monitor. Changing global trade patterns, currency fluctuations, recessions, wars, even the weather, whose occasional droughts and deluges can ruin an entire year’s agricultural crop — any of these could send prices soaring or crashing.

And after more than a decade when China’s industrialisation, and its insatiable demand for raw materials, seemed to justify ever higher commodities prices, the whole asset class slumped during the 2008 financial crisis and has not recovered old highs.

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Counterintuitively, despite all that volatility, adding commodities to a portfolio may help an investor sleep at night. The factors that cause commodities to swing around are often independent of those that move the equity and fixed income markets, which means that commodities might well be a cushion in an investor’s portfolio during times when share prices or bonds are going down. That, at least, is the theory espoused by financial advisers who recommend a 5 or 10 per cent allocation to the asset class.

It has become easier to access the commodities markets. Buying a tanker-load of oil or a warehouse stuffed with grain has always been off limits to all but professional trading companies. The traditional way for individuals to invest was to set up a brokerage account and to venture into the futures markets. This is still the spiciest way to trade today; the leverage built into these derivatives contracts means that one can make big money from relatively small changes in a commodity’s price, but brokers can also demand large sums of money to cover potential losses and bad bets can go very sour, very quickly.

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Making long-only investments in commodity futures came into vogue about a decade ago, based on the premise that they offered inflation protection and equity-like returns without being correlated to stock markets.

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More conservative investors can now choose from a burgeoning number of commodities funds, including scores of exchange traded funds that can be as easily bought or sold as shares.

The ETF.com database shows 149 such funds in the US alone, ranging from single-commodity funds like the SPDR Gold ETF to the popular PowerShares DB Commodity Index Tracking Fund, which mimics the price movement of a broad basket of commodities.

Be wary of some pitfalls, however. The performance of many of these ETFs can diverge markedly from the headline price of a commodity — especially over the long run, if they are investing in futures contracts rather than buying the underlying commodity and sticking it in a warehouse.

Actively managed mutual funds are a popular alternative, and Pimco and Fidelity are among the industry titans with commodities offerings. Investors will find that professionally managed, diversified funds inevitably come with higher fees.

Gold retains a unique place in the commodities pantheon, even though it is decades since governments and central banks stopped using the metal as backing for paper currencies. Such is humankind’s historic attachment to gold, its fans argue, it can be counted on to retain its value even while currencies decline and empires fall. Certainly it remains a go-to investment in a financial crisis, and investors who see inflation around the corner will always consider gold a hedge against the declining real value of other assets.

The two largest commodities ETFs are both gold funds, and no other investment arouses such passionate debate, but the precious metal’s price remains as slippery as any other commodity. Gold — indeed like all commodities — belongs in the category of speculative trades rather than long-term investments.