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OK, we get the idea. Having commodities as part of our portfolios can reduce risk by offsetting big swings in stocks and bonds. But how do we actually do it?
That was the gist of reader responses to a recent column about reducing investment risk. The concept was fine, but I didn't finish the story. I said nothing about how investors with relatively small nest eggs could put a slug of commodities in their portfolios.
After the roller-coaster ride of 2007, we'd all like to have a bit more stability in our investments. If you can reduce risk without reducing return, well, that's right up there with apple pie.
In fact, Craig Israelsen, a Brigham Young University professor who showed that adding commodities reduces portfolio risk, has offered a solution. He calls it "quasi-commodities" -- mutual funds that serve as proxies for commodities.
Examining the 20-year period from 1987 through 2006, he found that a mixture of Vanguard Energy (VGENX), Fidelity Real Estate Investment (FRESX) and Vanguard Precious Metals and Mining (VGPMX) improved the return of a typical stock-and-bond portfolio while reducing risk. It also provided an improved return and reduced risk compared with a conventional portfolio with a Goldman Sachs Commodity Index component.
Another point of view
For the record, there can be lots of quibbling about this solution.Modern portfolio theory purists, for instance, would complain that commodities shouldn't be considered. They aren't an earning asset class. Treasury bills, bonds and equities of all kinds are assets that earn. Commodities, on the other hand, don't earn. They simply grow, or shrink, in market price. Over time, the price of commodities has barely kept up with inflation.
Gold is a good example. It was a great speculation when its price soared from $77 an ounce in 1977 to more than $800 an ounce by 1981. But cash held in gold was dead money for the next 26 years; its price didn't exceed $800 again until the fourth quarter of 2007.
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Purists would also say that investing in energy stocks, real-estate stocks or mining stocks is simply investing in sectors of the equity market. So it is neither commodity investing nor asset-class investing.
Commodity enthusiasts, on the other hand, would argue that it is better to own futures contracts than to own shares of companies that produce commodities. Reason: They expect commodity-price inflation. Periods of price inflation tend to hurt equity valuations, so you won't get the full benefit of rising commodity prices by investing in the companies that produce them.
Is there a final word on this? Sorry, no.
Lack of agreement on theory, however, shouldn't dampen the good news about practical investing. The growth of index investing, particularly in the burgeoning exchange-traded-fund-index market, has made it possible for small investors to build portfolios that take either path, the quasi-commodity path suggested by Israelsen or direct investment in a fund that tracks a commodity index.
A simple quasi-commodity portfolio solution can be found in the Couch Potato Building Block portfolios on my Web site. The original Couch Potato portfolio (50% domestic total market and 50% Treasury inflation-protected securities) provided a return of 8.34% for 2007. The Margarita portfolio, which adds the broad international EAFE index, returned 8.88%. Those are conventional asset-class portfolios.
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The Six Ways From Sunday portfolio, however, includes a real-estate investment trust (REIT) index and an energy index. It returned 9.15% for 2007. Significantly, the continuing surge in energy stocks (up 34.9% in 2007) completely offset the loss in REITs (down 16.5% in 2007), yet another indication that broad diversification helps to smooth your ride.
Another option is to invest in one of the exchange-traded funds that duplicate a commodity index. Three broad commodity index ETFs are iPath Dow Jones AIG Commodity Index Trust (DJP, news, msgs), iShares S&P GSCI Index Trust (GSG, news, msgs) and PowerShares DB Commodity Index Tracking Fund (DBC, news, msgs).
All three ETFs have expense ratios of 0.75%. This makes them expensive additions to an index-fund portfolio. Also, as commodity investing guru Jim Rogers has pointed out many times, the Goldman Sachs Commodity Index is heavily weighted with energy, so it's more of an energy index than a commodity index.
Questions about personal finance and investments may be e-mailed to scott@scottburns.com. Questions of general interest may be answered in future columns. More columns by Scott Burns can be found here and here.
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