Too late to join the commodities rush?

Do you fear you've missed the commodities boom over the last few years?

With commodities providing a very bumpy ride this year, many investors who were lucky enough to benefit from the run-up may be wondering if it's time to cash out, and those who have been sitting on the fence may be even more leery about anteing up.

Commodities have been one of the most talked-about asset classes over the last few years. And for good reason -- the Goldman Sachs Commodity Index gained more than 25% last year and produced an average annual return of more than 23% since the beginning of 2002. Commodities have actually been the best-performing asset class over the last 36 years, outperforming both domestic and international stocks and bonds, particularly during high-inflationary periods like the 1970s. (Read more about commodities in Tim Middleton's latest column, "Hedge this wild market with commodities.")

Financial-services companies have been rolling out products to meet the demand. Prior to 2002, there was only one fund for retail investors that tracked a commodities index. Today there are about nine different kinds of investment products -- ranging from exchange-traded funds to index funds -- that track a variety of commodity indexes.

A bumpy ride

Commodities are volatile, but over the long run they can reduce the overall volatility of a portfolio because they provide diversification, i.e. they don't move in tandem with the other assets in a traditional portfolio. Commodities are tangible assets -- assets you can touch -- which are different from capital or financial assets, such as stocks and bonds. Their unique nature means that economic factors drive their prices differently than they drive the prices of capital assets. For example, when inflation rises, both stocks and bonds tend to decline, but commodities rise. Commodities actually have a negative correlation with the capital markets, meaning that they tend to move in the opposite direction.

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If you think you can handle the volatility of commodities without panicking during a downturn (the investor who sold after losing almost half his investment in '97-'98 would have missed out on the 254% growth that followed), then commodities may be a good addition to your long-term portfolio.

But not all commodity investment products are alike. There are three main ways to gain exposure to commodities:

• Direct physical investment.

• A portfolio of commodity-related stocks.

• A fully-collateralized commodity index.

Though buying gold Krugerrands and silos of corn is possible, direct physical investment isn't very practical. On the other hand, commodity-sector funds (mutual funds that invest in commodity-related companies) are much more accessible.

But those funds don't provide a "pure" exposure to the asset. These funds expose investors to the management skills, practices and the additional business lines of the companies represented in the portfolio, in addition to commodities. In fact, a 2005 study by finance professors Gary Gorton from the University of Pennsylvania's Wharton School and K. Geert Rouwenhorst from the Yale School of Management found that commodity-related companies were more closely correlated to the S&P 500 index ($INX) than to futures that tracked actual commodity prices.

The purest play

But not all indexes are alike. Many asset classes have multiple proxies that are reasonable substitutes for each other. For example, broad equity market indexes like the Russell 3000 index ($RUA.X), the S&P 1500 SuperComposite and the Dow Jones Wilshire 5000 index ($DWC) all have similar performance characteristics.

But for some asset classes, such as commodities, fewer choices and more disparity exist in the performance characteristics among the index choices. Some commodities indexes have more than double the standard deviation, or volatility, of others.

Note: *A measure of index volatility. **Gorton and Rouwenhorst commodity index is a scholarly project involving construction of an index of commodity futures monthly returns from July 1959 to December 2004 to study the asset class.

This disparity in risks and returns is due to the variation of what comprises the indexes. Some have a greater concentration of high-volatility commodities like crude oil and natural gas while others have more agricultural products. Before investing in an ETF or index fund, investors should understand the makeup of the index being tracked to ensure that they are taking on appropriate risk.

But is this the right time? Well, it's difficult to say. The last time commodities had a similar appreciation was in 1999 and 2000, when the Goldman Sachs Commodity Index jumped 111%, which was followed by a 32% decline in 2001. On the other hand, commodities have had longer runs of positive returns. For example, they produced a streak of positive returns for nine years straight from 1982 through 1990, returning more than 300%.

Investors who got in at the beginning of the run-up should evaluate their portfolios to see if their allocation to commodities has grown too large and risky, and should think about rebalancing. Investors who are still sitting on the fence should consider two factors -- time horizon and risk tolerance.

From a financial perspective, a long-term investor can weather even an extended downturn in an investment, but that doesn't mean he or she can handle it from an emotional perspective. Investors with a low tolerance for risk -- prone to selling at a downturn -- should not invest in commodities. And finally, investors should not overexpose themselves to any alternative asset class. Even though commodities have attractive characteristics, they probably shouldn't account for more than 5% to 15% of the average investor's portfolio.

Roger Ibbotson is founder of Ibbotson Associates, a Morningstar company, and a professor of finance at the Yale School of Management.

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