Hot Commodities

The term “proven commodity” is dead–on accurate when it comes to investments: Time after time, commodities have proved resilient in downturns.

For instance, natural resources funds stayed in the black while the S&P 500 lost more than 10 percent annually over the last three years. In 1974, when the S&P dropped 26.5 percent, the Goldman Sachs Commodity Index gained 39.5 percent. Natural resources also held their ground during the market collapses in 1987 and 1990.

Simple economics explains why commodities often rise when equities fall. During periods of economic expansion, commodity inventories grow scarce and prices rise. That unnerves equity investors who begin dumping shares of companies that face higher costs. Wars and other political problems can also cause shortages of oil and other resources, which unhinges equity markets.

A Natural Way to Diversify

Because they have so little correlation with stocks or bonds, natural resources can provide powerful diversification, reducing risk and possibly boosting returns, says Peng Chen, research director of Ibbotson Associates, the Chicago investment firm. To measure the value of holding hard assets, Ibbotson conducted a study that examined a medium-risk portfolio holding 50 percent of its assets in stocks and 50 percent in fixed income. The researchers found that if 20 percent of the assets were shifted into natural resources stocks and other commodity holdings, expected returns would rise and so would the Sharpe ratio, a measure of returns per unit of risk (the higher the Sharpe ratio, the better).

Chen says that even a small amount of natural resources holdings can help to anchor a portfolio. “Natural resources stocks often tend to be relatively stable because the companies own actual commodities that have clear values,” he says. “Other stocks may be riskier because they depend on uncertain business operations.”

For all their value as diversifiers, natural resources can suffer setbacks, sometimes underperforming the broader market for long periods. After having a nice run, could the sector now be headed for a stretch in the doldrums? Probably not, say many analysts, who argue that an unusual set of circumstances should continue propping up natural resources shares for some time.

After the Asian currency crisis began in 1997, demand for commodities slipped, and prices collapsed. With stock prices down, many companies stopped building new nickel mines and oil refineries. The underinvestment became more severe as Wall Street lost interest in commodities and focused on technology, supporting massive overbuilding of semiconductor facilities and fiber-optic cables. In recent years, with China growing rapidly, demand for commodities has begun surging. Now underfinanced facilities are being stretched to their limits, and supplies are running short.

“China is the new 800-pound gorilla in the world, which is sucking up commodities in a way that we have not witnessed for a long time,” says Lawrence Scharf, a financial adviser with Advest Inc. in Westport, Conn. He suggests that clients put at least 10 percent of their assets in natural resources funds.

Plays that Pay

One of the purest ways to play rising commodity prices is Oppenheimer Real Asset, which has an R-squared of 1, suggesting that the fund rarely moves along with the S&P 500. Portfolio manager Kevin Baum aims to roughly track the Goldman Sachs Commodity Index. To accomplish the task, he owns bonds and other securities that rise and fall along with commodity prices. Most assets are in oil and gas because the Goldman Sachs benchmark seeks to reflect the composition of world commodity markets, with two-thirds of the weighting in energy and the rest in a mix of metals, such as copper, aluminum and agricultural products, including orange juice and sugar. Investors seeking big stakes in metals may question the index weighting, but Baum argues that the emphasis on energy can be valuable, offsetting losses that occur when the overall market drops.

“If oil and gas prices rise 40 percent, then that will be a drag on equity markets,” he says. “But if there is a 40 percent rise in prices of sugar, then the impact on the markets may be limited.”

Investors seeking a broader portfolio may prefer PIMCO Commodity Real Return Strategy, which tracks the Dow Jones-AIG Commodity Index. That index limits energy to 33 percent of the total weighting, putting more emphasis on metals and commodities such as soybean oil.

Cautious clients should consider T. Rowe Price New Era, which holds natural resources stocks such as ExxonMobil and Phelps Dodge, the copper producer. Such blue-chip stocks tend to move more gradually than the commodity index tracked by Oppenheimer Real Asset. While commodity prices can twitch violently in response to short-term moves in supply and demand, stocks reflect the outlook of investors for conditions12 months in the future. Lately many oil stocks have behaved perversely, dropping while oil prices climbed above $30 a barrel. T. Rowe Price portfolio manager Charles Ober says the stock dips present a buying opportunity. “The stocks are acting as if prices are going to drop to $18, but I think the markets will stabilize at around $24,” he says.

Another relatively tame fund is Van Eck Global Hard Assets, which keeps a broad mix of stocks. Currently holding 41 percent of assets in energy, the fund tempers that position by having 6 percent in real estate and 8 percent in forest products. Last year the fund scored big gains by keeping up to 25 percent of assets in precious metals, but lately the position has been reduced to 17 percent. “Now that gold prices have climbed, it is time to back off a bit,” says Sam Halpert, an analyst for the fund.

Whether conservative or aggressive, though, the natural resources holdings can be an excellent portfolio-balancing tool for these uncertain times.

Against the Grain