HOT COMMODITIES? - Investools

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800-669-3900 11. At the same time, analysts and economists have made the case that commodities have a place in individual investors' portfolios.

BY RICK SINE

HOT COMMODITIES? COMMODITIES MAY HAVE THE POWER TO SMOOTH OUT A PORTFOLIO’S PERFORMANCE. Commodities were once considered to be only for professionals: traders working in a pit or savvy institutional money managers in search of alpha that was out of reach of individual investors. But in the past few years, a proliferation of mutual funds and Exchange Traded Funds (ETFs) has made it simpler for investors

At the same time, analysts

to bring gold, oil or wheat into their portfolios. Other financial

and economists have made

products also allow individuals to buy and sell commodity futures.

the case that commodities have a place in individual

investors’ portfolios. Used properly, experts say, commodities can be an effective diversification tool, possibly reducing the volatility in equities and fixed income.

Counterintuitive Volatility Like most investment categories, commodities tumbled during the 2008 financial crisis. As a class, most rebounded, only to tumble again in the spring of 2011. Such volatility is hardly new: Commodities’ volatility for the 25-year period through 2004 was higher than that of any other asset class except international stocks, according to a study by Ibbotson Associates.1

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COMMODITIES

Great Expectations Indeed, talk to economic optimists and you’ll hear that the financial crisis — and the spring 2011 drop — were bumps in the road for an asset class with great long-term prospects. They believe commodities will benefit greatly from global economic expansion. In emerging markets such as China, India and Brazil, a rapidly growing middle class is yearning for luxuries previously out of reach, such as cars and appliances, and is expanding its diet beyond the basics. “As their governments build infrastructure and citizens’ lifestyles start to mimic those of their counterparts in developed countries, demand will likely boost commodities prices,” says Joe Kinahan, Chief Derivatives Strategist at TD Ameritrade. Commodities also appeal to economic pessimists who appreciate the value of hard assets in the face of economic uncertainty. The Ibbotson study confirms the common perception that commodities perform well during periods of rising prices. During the high inflation of the 1970s, commodities outperformed every asset class measured, including U.S. and international stocks and bonds.1

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ALL YOUR COMMODITIES — IN ONE BASKET Commodities investing is as simple today for the longterm investor as it is for someone who buys and sells frequently. But the strategies employed by each group tend to differ. “For the long-term investor focused on asset allocation, we generally suggest holding about 5% of a portfolio in commodities,” Ibbotson’s Thomas Idzorek says. For investors seeking a “one-and-done” commodities investment, a range of mutual funds and ETFs buy into a basket of commodities, whether through stocks or futures contracts. The most popular of these funds attempt to mimic commodity indices such as the Goldman Sachs Commodity Index, the Reuters/ Jeffries Commodity Research Bureau, the Dow JonesAIG Commodity Index and the SummerHaven Dynamic Commodity Index. An index-linked fund can be a good way to own a diversified commodity portfolio with a single purchase. But unlike stock or bond indices, there are no rules governing what should be included in a commodity index. Therefore, their composition can vary significantly. Most indices tie their weighting to global production value, but some also factor in liquidity or set limits on the proportion of the portfolio that can be invested in a single commodity to boost diversification. All these decisions can lead to varying performance among the indices.

In an era of lower U.S. growth, commodities may also provide a hedge against a weakening dollar, notes Peter McGratty, Managing Director of Precursor Research, a research firm for investment advisors. “The Federal Reserve can print money, but you can only make so many commodities,” McGratty explains. “Lack of supply creates a certain amount of value.” Investors concerned about the economic future have historically turned to gold, in particular. Although gold fell to $714 per ounce in 2008, it was trading at over $1,500 an ounce in April 2011, according to the London Bullion Market Association.2 Many investors already have investments in companies with commodities exposure through positions in large cap funds, notes Mike McGrath, Director of ETF Product Strategy at TD Ameritrade. That’s due largely to the presence of big energy companies like Exxon Mobil and Chevron in their largest holdings. “Individuals who are seeking more specific exposure to commodities are usually speculating [on rising prices], seeking to diversify a portfolio or seeking an inflation hedge,” McGrath says.

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Commodity markets generally share a low correlation with stocks, bonds and cash, Ibbotson also found. As a result, portfolios that included commodities performed better over the 1970–2004 period than those that did not — without increasing volatility. “Adding a sliver of commodities may ultimately smooth out the roller-coaster ride of your overall portfolio,” says Thomas Idzorek, CFA, Research Director for Ibbotson. Idzorek says the low correlation between commodities and other assets he observed from 1970–2004 is likely to continue. Correlations were high for many investment assets during the 2008 crisis, but Idzorek called the crisis “a unique event” during which investors fled from almost all risk. K. Geert Rouwenhorst, a finance professor at Yale University who has written about commodity investing, agrees that commodities will continue to move independently of other investments. COMPARISON “Over the past 50 years, the corSHOP relation between commodities and To review and stocks, on average, has been pretty compare commodity close to zero,” he says. prices, log on to Why this low correlation? The factdameritrade.com tors that drive commodity prices appear and go to: to be largely unrelated to those that QResearch & Ideas drive other assets, Idzorek explains. “No QMarkets matter what the other assets are doing, QCommodities commodities generally march to their own drum.”

Stocks: Can They Stand In for Commodities? If you’re considering adding or tweaking a commodities allocation within your portfolio, you have a number of choices. One is to invest directly in shares of gold miners, wildcatters, tractor makers and the like. Buying stocks in these types of companies is, to some degree, a bet on the price of a raw material (gold, oil and farm REFINE YOUR products, respectively). Investors SEARCH who are interested in commodities To sift through and accustomed to picking stocks commodity-linked may be comfortable choosing shares companies, log on to of individual companies that refine, tdameritrade.com process or distribute raw materials. and click: Beyond benefiting from comQResearch & Ideas modity price increases, investors Q Screeners in commodity-linked stocks can Q Create Stock also reap benefits from a company’s Screen management skill and technological Q Basic efficiencies. But this is a doubleQSector & Industry edged sword, Rouwenhorst observes: The stock of a poorly run company

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IT TAKES ALL KINDS

METALS include precious metals (such as gold, silver and platinum) and bulk metals (including nickel, copper and aluminum). In early March 2011 gold and silver were near historic highs, thanks in part to inflation fears. Kinahan notes that precious metals have a history of extreme volatility. “Metals have shown such incredible strength, I don’t know if I’d buy,” he says. For investors who do own precious metals, he says, “I’d have stop orders or puts on the downside, because when that plug gets pulled, it seems prices may fall very quickly.” GR AINS include corn, wheat and soybeans. Kinahan says foodstuffs can be a great long-range bet, because as people in emerging markets grow more affluent, they are going to be eating more and diversifying their diets.

NOT ALL MINERS STRIKE IT RICH The performance of a commodity and the stock of its producers can vary considerably. For example, in 2010, gold bullion gained 29.5%. But thanks to a wave of acquisitions, some “junior miners” did much better, according to the annual report for the Van Eck International Investors Gold Fund: Takeover targets Red Back Mining and Andean Resources gained 140% and 176%, respectively. Meanwhile, U.K.-based Randgold Resources was up only 4.3% for the year. Randgold was facing operational difficulties at one of its mines, and political turmoil was affecting the startup of another, Van Eck reports.

may suffer even if the underlying commodity performs well. (See “Not All Miners Strike It Rich” sidebar.) Many companies also operate non-commodity-related divisions, or they actively hedge the costs associated with their business, reducing their exposure to the underlying commodity price swings. As a result, investing in commodity-linked equities fails to completely capture one of the most appealing

Investors can choose from more than 30 tradable commodity types. Here is a sampling of the most common varieties, with an update on current market conditions for each.

ENERGY includes oil, natural gas and coal. Although vehicles don’t yet exist to trade renewable energy futures, you can buy shares in solar and wind energy companies. As Enlightened Investor went to press, oil prices were rising in response to political turmoil in the Middle East. “Oil prices also tend to rise going into the summer driving season,” notes Kinahan.

SOFTS include coffee, cotton, cocoa, sugar, orange juice and other agricultural commodities. For investors who find agriculture appealing but do not want to buy and sell individual futures, agriculturefocused ETFs offer the opportunity to own a diversified set of agriculture futures or shares in a single fund.

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qualities of commodities — the low correlation with other asset classes. Rouwenhorst found that the correlation of commodity-linked companies is closer to the S&P 500 than to commodities futures. However, says Kinahan, “By doing their homework on a company’s business, investors can help to ensure that its stock is closely linked with whichever commodity an investor favors.” For example, a company that makes fertilizer should have a close linkage to rising prices of agriculture commodities. By contrast, the performance of a farm equipment maker will also be linked to agriculture — but it also may be linked to oil prices in ways that can counteract the impact of agriculture prices.

Commodities for Income Investors Equities provide a wide variety of opportunities to gain commodity exposure. In addition to buying shares of operating companies, income-oriented investors might tap Master Limited Partnerships (MLPs). These securities usually invest in energy infrastructure such as oil pipelines and are traded just like other stocks on public stock exchanges. MLPs are exempt from corporate taxes, so they can distribute a larger proportion of their after-tax income to shareholders. And they are legally required to distribute available cash back to shareholders each quarter. Their high yields can be appealing, but their special tax treatment can also yield more paperwork at tax time.

3 WAYS TO INVEST IN COMMODITIES

ETFs and Mutual Funds for Focused Asset Allocation

Much of the growing interest in comTo review focused modities can be traced to the emerasset allocations, gence of a wide range of commoditylog on to linked ETFs and mutual funds. The tdameritrade.com to: last few years have seen a significant Find ETFs for almost increase in the number of ETFs that any type of traded employ a variety of investing stratecommodity: gies. Some funds focus on a single QResearch & Ideas commodity such as gold, oil or natuQETFs ral gas. Some gold and silver funds Q Gain Exposure To are tied directly to storehouses of the Commodity Markets precious metal, allowing the investor Find Mutual Funds to make a direct investment without that are evaluated having to be concerned about storby the independent age or security. Other funds invest experts at Morningstar in commodity-linked stocks. HowAssociates: ever, the most common are based on QResearch & Ideas futures contracts. QMutual Funds Before buying an ETF, McGrath Q Premier List recommends reading its prospectus to gain a clear understanding of its objectives, risks, charges and expenses. It’s important to know what type of exposure you are getting, and how the ETF is getting it. You may also want to pay particular attention to the reasons an ETF may or may not closely track the underlying commodity

PROS ▪ Familiar to many investors

INDIVIDUAL STOCKS

▪ Easy to track investment ▪ May benefit from good company management

as well as commodity price changes ▪ Can invest in many different commodities

ETFs / MUTUAL FUNDS

in one purchase ▪ Convenient way to invest in futures (for futures-linked funds) ▪ The most direct way to invest in commodities,

FUTURES

short of actual ownership ▪ Use of leverage increases potential for

significant gains

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GET IN THE GAME

CONS ▪ May have less asset allocation benefit than

futures-based investments ▪ May be hurt by poor management

▪ Highly variable structure and performance ▪ Less control over buying and selling compared

with direct investment in stocks or futures

▪ Relatively technical ▪ Use of leverage increases potential for

significant losses

READY FOR FUTURES? Log on to tdameritrade.com to: Apply online for a Futures account :

(or commodities). “The typically lower expense and transparency of ETFs have made them one of the biggest growth stories in commodity investments for individuals,” he says.

Futures: The Purest Play

QClient Services

A futures contract is an agreement to buy or sell a quantity of a commodQForms & Agreements ity at a set price on a certain future Q Futures Account date. Futures investors use leverage Application — that is, they make bets of significantly larger dollar value than their Check out Futures initial outlay — which magnifies investments from gold to grain: both the potential gains and potential losses from commodity futures QTrade investing. As such, futures investing Q Futures is best suited to investors who have the financial capacity to take risks, a thorough understanding of investing techniques, and the time to closely track their investments. “Futures are considered by many investors to be the ‘purest’ way to gain exposure to commodities,” McGrath says. “But futures investing can be unpredictable. Futures traders spend hours reading economic forecasts, scanning weather data, researching regional economies and even tracking natural disasters to gauge potential trends in commodity production and demand.”

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“ FOR THE LONG-TERM INVESTOR FOCUSED ON ASSET ALLOCATION, WE GENERALLY SUGGEST HOLDING ABOUT 5% OF A PORTFOLIO IN COMMODITIES.” – Mike McGrath, Director of ETF Product Strategy TD Ameritrade

The View Ahead The increasing interest in commodities investing has led to concerns that some commodities markets are being moved by speculation. But many other markets — from stocks to real estate — are prone to speculation as well, notes Lee DeLorenzo, CFP, President of United Asset Strategies, an investment advisory firm in Garden City, N.Y. Proponents of commodity investing suggest its benefits will grow. “The investment opportunities of the future will increasingly come from the fast-growing economies of Asia,” writes John Stephenson, author of The Little Book of Commodity Investing. “And that’s good for commodities, the real stuff that makes economic expansion possible.” I

“Strategic Asset Allocation and Commodities,” Ibbotson Associates, March 27, 2006. 2 London Market Bullion Association, April 20, 2011 (gold at $1,505).

TD Ameritrade is not responsible for information, opinions or services provided by third parties. Market volatility and system availability may delay account access and trade executions. Asset allocation and diversification do not eliminate the risk of experiencing investment losses. Past performance of a security does not guarantee future results or success. Content is provided for illustrative and educational use only and is not a recommendation or solicitation to purchase any specific security. Commodity ETFs may be affected by changes in overall market movements, commodity index volatility, changes in interest rates or factors affecting a particular industry or commodity. Commodity ETFs may be subject to greater volatility than traditional ETFs and may not be suitable for all investors. Unique risk factors of a commodity fund may include, but are not limited to, the fund's use of aggressive investment techniques such as derivatives, options, forward contracts, correlation or inverse

correlation, market price variance risk and leverage. Emerging markets investments involve special risks such as exposure to economies that are less diverse and less mature than more established markets, significant price volatility risks due to currency fluctuations, and political and economic instability. Futures trading is not suitable for all investors. It involves speculation and the risk of loss can be substantial. Clients must consider all relevant risk factors, including their own personal financial situation, before trading. Morningstar Associates, LLC is a registered investment advisor and wholly owned subsidiary of Morningstar, Inc. The mutual funds selected by Morningstar Associates for the Premier List have been derived from a universe of mutual funds made available through TD Ameritrade. Particular mutual funds on the Premier List may not be appropriate investments for you under your circumstances, and there may be other mutual funds or investment options offered by TD Ameritrade that are more suitable. TD Ameritrade, Inc. and Morningstar, Inc. are separate, unaffiliated companies.

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