Adding Commodities to Your Portfolio? Not So Fast

Investing tip of the month from Morningstar Investment Research Center, by Christine Benz, Director of Personal Finance

With growth in emerging markets continuing apace, it's easy to assume that demand for commodities such as oil, metals, and food products will march inexorably higher, too.
It's also tempting to want to position your portfolio to benefit from price gains in commodities. If you're going to have to fork over more cash to fill up your gas tank and your kitchen cupboards, why not try to earn back at least some of those extra costs by owning commodities or the companies that sell them?

A lot of investors clearly have the same idea: Mutual funds in the natural-resources category, which houses energy- and commodities-focused funds, raked in $4 billion of new assets in May 2008 alone, the second-largest haul of any fund type. And we've seen a rush of new investment options--mainly exchange-traded funds--coming to market.

Time to Wade In?
So, should you join the throngs flocking to energy and commodities? Recent returns have certainly been scorching: As worrisome signs about inflation and the strength of the U.S. economy have been dragging down the broad market, commodities, energy, and basic-materials securities have been a rare bright spot. From early 2002 through May, the Goldman Sachs Commodity Index gained nearly 20% per year on average, versus a 5% gain for the S&P 500. And while the 15-year returns of the Goldman Sachs Commodity Index and the S&P 500 are neck and neck (gaining roughly 10%, on average, per year), there was little performance correlation. So, commodities clearly are a worthwhile diversifier as a small part of a long-term portfolio.

Nonetheless, the contrarian in me gets very nervous when investors stampede into any asset class, whether it's technology stocks or houses. I'm not about to call a top in commodities, but I can't help but wonder whether the smart money has already been made. It also makes me nervous that hedge funds, some of them betting with borrowed money, have been among the biggest investors in commodity-related investments. Should they start reversing their bets or be forced to sell securities to meet redemptions, the fortunes of commodities and commodity-related stocks could take a hit. Finally, it also stands to reason that rising prices, at some point, will tamp down demand for energy and basic materials.

Similarly, several fund managers speaking at Morningstar's Investment Conference in late June expressed caution about the area. Of course, you'd probably expect that managers who have long avoided energy stocks, such as Peter Langerman at Franklin Mutual Shares and Bob Torray at Torray Fund still don't like them. (If they weren't biting when oil was trading at $70 a barrel, let's hope they don't like energy stocks now that the price of oil has doubled!) What really gets my attention, however, is when a manager who has made good money in energy-related stocks, such as Bruce Berkowitz at Fairholme Fund, decides to take some profits and invest elsewhere. (Fairholme still has a decent-size weighting in energy, but Berkowitz says that he has been scaling back and putting the money to work in health-care stocks.)

Look Before You Leap
An even bigger reason to be cautious about adding energy- and commodity-related investments at this juncture is that you may well already have a fair amount of exposure to these areas already. Even if you don't own a commodities fund that specifically tracks commodity-price performance, if you own mutual funds, you're likely to own shares of public companies that extract and distribute commodities. Over time, the performance of these stocks hasn't precisely tracked commodity prices, but it has tended to move in the same general direction.

Even if you've not added dedicated energy and basic-materials stock exposure, it's a good bet that some of your fund managers have. Managers from across the value/growth spectrum have been adding to their stakes in energy and basic-materials stocks over the past few years. Even a tack of benign neglect would have resulted in a higher energy-stock stake, owing to the sector's massive appreciation since 2002. The Dow Jones Wilshire 5000 Index's position more than doubled during that time frame. Fund managers have also been aggressively adding to their commodities-related holdings outside of the energy sector, and it's not unusual to see mining companies and agricultural-product purveyors in diversified fund portfolios these days.
You may also have compounded your exposure without knowing it by adding to your winners. If you own a mutual fund that has performed markedly better than your other holdings over the past few years, chances are that fund has a fair amount of exposure to energy and other basic materials.

Ditto if you are among the legions of investors who have bought or added to an international, global, and/or emerging-markets fund over the past several years. Several of the fastest-growing international markets, ranging from India to Brazil to Russia, owe at least part of their recent success to spiking demand for oil, metals, and other basic materials. (Many of these economies happen to have rich reserves of commodities.) In fact, energy stocks currently account for about 18% of the MSCI Emerging Markets Index, and some of the more aggressively positioned funds hold an even larger stake than that. The "Industrial Materials" sector, which houses basic-materials companies as well as manufacturing firms, accounts for another 20% of the index.

Find Your Baseline
One starting point for gauging how much exposure you have to such securities is to use Morningstar Investment Research Center's Portfolio X-Ray tool to check up on your portfolio's current positioning. Simply enter the dollar amounts and ticker names for each of your holdings, then click Show Instant X-Ray. You'll be able to see your portfolio's stock/bond/cash mix, as well as your investment-style and sector positioning. You can then compare that sector positioning with that of the S&P 500.True, owning a lot in energy and industrial-materials stocks isn't the same as owning an index fund that tracks actual physical commodities. But if your exposure to those sectors is high, that should set off alarm bells about adding commodities at this juncture. And in any case, those looking to add a dedicated commodities fund shouldn't do so expecting overnight riches but instead should consider it part of a long-term asset-allocation strategy.

Morningstar Investment Research Center is great tool for new and veteran investors. It's chock full of unbiased analyst reports, tools for evaluating your portfolio, and lessons on how to invest. The best part is that it's free to all valid library cardholders! Begin now or learn more.