BOSTON (MarketWatch) Given the specter of inflation and the need to rebuild Japan in the wake of the quake and tsunami, investors are going wild over commodities these days.
And that interest is leading many average retail investors to ask the question: What's the best way to hop on this train?
For some, the best way to take advantage of these trends is to buy single-commodity exchange-traded funds or exchange-traded notes, from which there are plenty to choose.
For instance, Jeffrey Sica, the president and chief investment officer of SICA Wealth Management, sent out release this week with a laundry list of single-commodity securities "that will appreciate in value," including gold (SGOL) ,
Others say, however, that buying single-commodity ETFs or ETNs works for some investors, but not so much for those who simply want to add an asset class that isn't highly correlated to stocks and bonds.
The reasons for this are many. For instance, Frank Holmes, the CEO, chief investment officer for U.S. Global Investors and manager of the U.S. Global Resources fund
To illustrate those price fluctuations, U.S. Global Investors produced what it calls the Periodic Table of Commodity Returns. That table shows how the price of 14 commodities have ebbed and flowed over the past the decade, and illustrates the principle of mean reversion the concept that returns eventually move back towards their mean or average.
For instance, the table shows that palladium was out of favor in 2008, falling 49.29% that year, but in favor the following two years, rising 118.07% in 2009 and then 96.6% in 2010. And that story gets repeated with other commodities as well, be it aluminum, coal, copper, corn, crude oil, gold, lead, natural gas, nickel, platinum, silver, zinc, wheat and so on.
See U.S. Global Investors' Periodic Table of Commodity Returns here.
According to Holmes, the price movement of commodities "is historically both seasonal and cyclical," but the price is also affected by government policies and well as other factors, and acts of God, such as earthquakes and tsunamis.
And that's why all but those who have the time, desire and knowledge to track such things as coal production trends in Australia or zinc consumption in China are better off with broad-based commodity mutual funds or ETFS and ETNs.
Others agree, including Morningstar analysts Abraham Bailin, who follows commodity ETFS, and Kathryn Young, who covers commodity mutual funds.
"If you are looking to gain broadly based commodity exposure within your portfolio for asset allocation purposes, there are couple reasons that you will want to do that," said Bailin. "The first and most timely, is that you are looking for a level of inflationary hedging. You are looking for access to hard assets. The second major benefit that you will be looking for, with a broadly based commodity offering in the core of your portfolio, is a diversification away from the correlation of traditional asset classes, such as stocks and bonds."
PowerShares DB Commodity Index Tracking, which provides good long-term exposure to a diversified basket of 14 commodities, tracks the Deutsche Bank Liquid Commodity Index and is the largest of its kind. "That fund uses a quantitatively-based methodology to select on a month-over-month basis the best contracts to participate in, in terms of the futures curve," he said.
United States Commodity Index Fund is a "rules-based dynamic exchange-traded derivative fund with two objectives," wrote Bailin in a recent research report. "It provides exposure to the most important and most liquid physical commodities in the global economy, and it attempts to achieve higher risk-adjusted returns when compared with funds tracking traditional commodity indexes."
He said USCI tracks the SummerHaven Dynamic Commodity Index by holding 14 of 27 eligible commodities. "Monthly inclusion rules first target the seven most heavily backward-dated commodities and then the seven commodities with the largest annual price change, but will make adjustments to ensure representation of all six commodity sectors," he wrote.
"This fund is as dynamic as any active manager is going to be," he said in an interview. "You get a dynamic alpha-seeking exposure within your broadly based commodity allocation."
By the way, alternatives to the aforementioned include iPath Dow Jones-AIG Commodity Index Total Return ETN (DJP),
And for those who want a different sort of fund in addition to a broad-based commodity fund, Bailin suggested the ELEMENTS S&P Commodity Trends Indicator (LSC),
Bailin said owning the ELEMENTS S&P Commodity Trends Indicator, which uses a momentum strategy, is the near equivalent of shorting top-performing commodities and going long bottoming performing commodities. And its performance reflects that strategy: It did well in 2008, bottomed out in the summer of 2010, and it's been trending upwards ever since.
That's not to say you shouldn't buy the ELEMENTS S&P Commodity Trends Indicator. Rather, consider buying it as a way to capture some of the upside associated with momentum strategies and earmark for the more speculative segment of your portfolio rather than the commodity portion.
"The major issue with a long/short strategy is that if you are looking for inflationary hedging, what you are looking for in that segment of your portfolio is full participation all the time, because the likelihood that you are going to be able to accurately predict an inflationary driven run-up in the short-term is relatively low," he said. "If you are basing your moves on a momentum factor, it's going to take you several months to shift out of those shorts and into those long positions there's a drag because you are not pulling the trigger quickly on those long-to-short and short-to-long positions, and you are not participating in the long side of the market. So you are not guaranteed to capture all of that upside."
As for those who might want an open-end, broad commodity mutual fund, Morningstar's Young suggested Harbor Commodity Real Return Strategy fund
What's more, she noted that the fund is managed by the same person which is managed by Mihir Worah, who also manages PIMCO Commodity Real Return Strategy Fund
FYI: If you are thinking about investing in single-commodity funds, consider this bit of advice. "You are doing so for different reasons," said Bailin. "You don't have the same objectives. You'd be misguided to assume that you are shooting for the same target as you would by owning a broad-based commodity fund," said Bailin.
To be sure, you could target single-commodity funds such as those in Power Shares DB family of funds and play the reversion-to-the-mean game, but that would be considered more speculative than prudent asset allocation. "If you are targeting a specific commodity or subsector you are really exposed to the underlying price pressures that affect that particular commodity whether they be seasonal or whatever," Bailin said.