SHOULD YOU HAVE A PIECE OF YOUR INVESTMENTS IN COMMODITIES?
By Rob Wrubel, CFP®
Today, the Federal Reserve put into place another round where they will inject money into the economy. This is the second round of “quantitative easing” or QEII and is designed to keep interest rates low to help stimulate demand in the economy and to help mortgage borrowers and refinancers access low-cost capital.
Through QEII, the Fed will continue to buy longer-term bonds. They are a significant, if not the dominant, buyer in the market and their demand is a powerful force serving to keep bond yields low.
The FED has indicated that they prefer to see the beginning of inflation than any continued potential spiral of deflation. Additional capital in the market has the potential to be inflationary as you have more dollars circulating that chase the same or fewer goods.
This brings up the real topic of this month’s Wealth Notes. Should you have a piece of your investments in commodities? Historically, commodities have given investors a chance to profit in inflationary environments. Commodities typically act differently than stocks over different periods of time providing potential diversification.
First, what do we mean by commodities?
Commodities usually refer to tangible assets and are broken down into five major categories (with samples shown):
1. Energy—gasoline, oil, natural gas
2. Industrial metals: aluminum, copper, lead, nickel, zinc
3. Precious metals: gold and silver
4. Livestock: cattle, hogs
5. Agricultural products: wheat, corn, soybeans, cotton, sugar, coffee
Commodities are traded directly on futures exchanges. Historically, end-users had the most interest in trading commodities. Companies like Ford and GM that need steel to produce cars buy futures to guarantee they will have enough steel for the year. Cereal companies like Proctor & Gamble might buy corn and wheat on the futures market to lock in their prices for the amounts they will need as they produce their goods. Big companies do not have to have contracts with individual farmers, miners and producers and can buy more efficiently through the markets.
Recently, individuals and institutions have decided that commodities can play a role in achieving their investing goals. Commodities have not been correlated to either stocks or bonds. This means that they may be up or down relative to stocks and bonds but may be impacted by other factors than stocks and bonds.
Direct investing in commodities does not work for most investors. Assume you invest directly through the futures markets. You may decide to purchase the right to own 10 bushels of corn with a delivery date of March 2011. You expect the price to rise as the date approaches and sell the futures to someone else. If the market moves against you and the price falls, you have two choices. One is to sell the contract at a loss (much like selling a stock but with a very short time horizon). The other is to take delivery of the corn. The market can be very volatile and you could easily lose your capital in a short period of time. Unlike owning shares of a publicly traded company, like IBM or Apple, you are forced to make a decision in a certain period of time. You cannot wait out the rough market for the futures contract to recover. Even worse, you could be stuck with truckloads of corn and need to hire a storage facility to hold it.
Today, most investors choose mutual funds or index funds when adding a commodity piece to their portfolio. These funds allow for daily liquidity, group ownership and professional management. There is no chance you will have a truckload of corn show up on your doorstep by owning a commodities mutual fund.
Why commodities now?
Investors first need to determine if the risks and volatility of commodities make sense for them. We can discuss that as part of our regular reviews and conversations.
For those who determine it makes sense there are several reasons why people have been rushing into commodities.
1. Economic recovery. The global recovery is well under way. Emerging markets especially are driving the increase in need for commodities. Emerging markets continue to industrialize and urbanize. Demand for homes, buildings, cars, trains, packaged goods and more increase as people in these countries join the middle class and seek to improve the quality of their lives.
2. Inflationary pressure. Demand looks to be outpacing supply as these countries grow. The FED unleashing cheap capital, through QUII, only adds fuel to the fire. Builders, manufactures and governments can make capital investments today using historically inexpensive money.
3. Low dollar. Commodities tend to trade in the global markets in US dollars. A low and depreciating dollar helps investment gains in commodities.
All of this does not mean you have to own a commodities fund. There are significant risk factors to consider.
Income oriented investors typically stay away from these investments. Most of the commodities funds do not pay dividends. You are 100% looking for capital appreciation in this case.
Volatility. It is often easier to understand the long-term potential for a stock or bond. The stock may be a company with significant growth potential in growing markets or they may be a dominant player in an established market. A bond will likely continue to pay its interest payments and mature on some expected schedule.
Commodities are harder to predict and understand. Gold especially is prone to huge speculation and emotional reactions that can increase or decrease the price quickly.
Banner years in agricultural products can quickly drive prices down. Rampant inflation can cause an economy to melt down if it happens too quickly.
We want our clients to understand the role different assets can play in a portfolio. Your needs and risk tolerances are key factors in deciding which assets and asset classes to own. Stocks, bonds, commodities and real estate can all play a role in investing for your goals. We welcome the opportunity to speak with you more about your portfolio and to meet with your other professional advisors to review tax, estate planning and retirement plan decisions that impact your financial and investment plans.