IT'S NO SECRET COMMODITIES

markets are thriving and have been for some time. The Dow Jones AIG Commodity Index, a benchmark composed of futures contracts on 19 commodities, returned 21% in 2005. The S&P 500 gained 4.9% over the same stretch. Gold hit a 25-year high last week, and copper and zinc set fresh highs earlier this month. Don't even get us started on oil, which currently sits above $70 a barrel.

Once associated with risky speculation, commodities' bad rap is long gone. And Wall Street, of course, is milking the trend for all it's worth, rolling out exchange-traded funds tracking the price of precious metals like gold and silver, as well as commodities-based index funds. With both big and small investors betting on commodities' continued ascent, the question now is whether it's become a too-crowded trade. Can commodities' rising prices still be taken advantage of or has all the good news and investor demand made the sector a bygone opportunity? Robert Weissenstein, chief investment officer at Credit Suisse Group's private bank, says the cycle is not over yet.

Commodities, especially the ones like copper and lumber that have industrial applications, are fundamentally a bet on economic growth, says Weissenstein. And faith in continued global economic expansion with demand coming from countries like China and India, in particular will propel commodity prices higher, he says.

Generally speaking, since commodity prices tend to go up when stocks and bonds go down, they serve to mitigate risk in a portfolio and hedge against inflation. Although individual commodities may experience bursts of volatility, says Weissenstein, a broad allocation can provide both downside protection and upside potential.

"[Commodities] potentially can add some returns, but you can see by the numbers that by adding a small amount, you can make a portfolio more efficient," he says. Weissenstein cautions investors not to chase returns in the oil or metals market by just throwing money into any old security. Many diversified portfolio already include companies in the energy or mining sectors, so adding to that might result in overexposure.

SmartMoney.com: Commodity prices have been rallying for quite some time. Is it too late for investors to get in them now?

Robert Weissenstein: Not necessarily. You have to think, is there a diversification reason to be invested in this space? Commodities [tend to have a] negative correlation with other assets, so they can reduce the overall volatility in a portfolio. That's a strategic reason. Maybe by themselves they're a volatile asset class, but the way they behave can have a mitigating effect in a portfolio.

The second reason, tactically, is their directional move. Commodities have been moving in one direction; we've seen every commodity energy, base metals, precious metals go up. Investors should understand why that's happened and what you're investing in them. One of the major indexes, the Goldman Sachs Commodities Index, is 70% invested in energy. So it's not accurately reflective of [the performance of] commodities overall. The Dow Jones AIG Index is far more balanced. One isn't right or wrong. Just know what you're looking at.

SM: What economic forces have been driving prices higher?

RW: One thing you have to separate out a little bit is, has the run been overdone? I think you have runs in different parts of the commodities space. Overall what's been driving commodity prices higher is overall economic growth. If you believe the economy is healthy, you can make the case that commodities will stay strong, particularly when you're looking at base metals like copper and zinc, which are used in construction and infrastructure. You can make the same case for oil, but be careful there because price spikes there are more for geopolitical reasons.

In precious metals there's more of a potential for a near-term correction than there might be in some of the others because it's been more attractive to momentum players. People flock toward gold because of fears of inflation, or price increases in oil, or geopolitical fears.... That's not saying precious metals like gold would fall apart by any means but that they might have more air. The China story is a huge one. The reality is that that's not a one- or two- or three-quarter story; that's a transformational story for the economy. Same with India. You think about infrastructure buildouts for countries like that, and you see there's a run in front of us. And there's also a supply constraint, so prices could remain interesting.

SM: Does the general theory that commodities are valuable in a portfolio because, as a hedge against inflation, they have a negative correlation to most other asset classes still hold, even after the significant run-up?

RW: Commodities have a negative correlation to a number of asset classes and the overall broad market. So when used in conjunction with an overall portfolio, they can in fact reduce volatility as a whole, even though at times commodities on a standalone basis can exhibit volatility. That's just the value of diversification. It potentially can add some returns, but you can see by the numbers that by adding a small amount, you can make a portfolio more efficient.

SM: How much of the current run-up in commodities is coming from hedge funds and institutional money managers?

RW: Anytime there's more heat around an asset class, you tend to see more fund flows in that direction. You see institutional players there. But also you see a broader base of private investors participating as well. It tends to feed on itself. As the non-U.S. [equities] theme was doing well, more people were going there.... People understand that oil prices are going up in their personal lives. They're aware of that as an investable space. The number of people, even in the last month or so, who want to talk about commodities when I talk to individual investors are so many more than a year ago. I talk to a lot of individual investors to get a sense of sentiment, and I can tell you in the last month or so people generally ask me more questions about [commodities] than a year ago. There's more buzz around gold. They understand it, they use it. Some of the baser industrial metals they understand less but they're at least at the stage where they want to know more about it. That's a very real phenomenon that I've noticed. When everybody made money in hedge funds, they wanted to talk about hedge funds. It's a normal progression of investor sentiment.

But there are fundamental reasons why many of these commodities have increased in price. Again you have oil and the geopolitical concerns. The economy continues to be healthy. There's global economic growth in China, some of the positive dynamics in Europe, our economy, some of the emerging markets have done well. That all creates demand.

SM: After all the positive news on this asset class, is there still room for it go higher?

RW: I think there's legs left in this. Anybody entering here, you're entering in the face of recent and significant run-up. If you had no position in the area you want to establish it carefully. You don't go from zero to full position overnight. You'll get corrections here and there, you'll get volatility. The cycle is probably not over. If you're looking out next year or the year after, you look at supply-demand characteristics, particularly base metals, I think you're maybe of couple of years into a multiyear trend. That doesn't mean it's a straight line up for five, six or seven years.

SM: Is gold still really a hedge against unforeseen negative events?

RW: It has not behaved the way people expected it to behave. It was looked at as a safe haven against inflation.... It seems to be we get price moves when there's uncertainty out there. When you see an unstable geopolitical environment like we see in the Mideast again, we are seeing price movements in response to that. There is still an element of safe haven or storehouse to gold, just not as directly as it used to be a long time ago. The actual use of it when you get past things like jewelry, there are no broad-based applications. It's not like copper, which is used to build infrastructure.

SM: It's unrealistic to own the assets themselves, so how could people make bets on lumber or orange juice?

RW: There are a number of different strategies you can employ to invest in commodities. And remember, anyone with a diversified portfolio is probably already invested in commodities in some way. The oil sector is not insignificant; if it's an S&P 500-oriented portfolio, oil is there. You can buy a commodity-specific mutual fund. There are ETFs for various sectors including gold, and they're talking about one for silver. You can invest in a mutual fund that follows or mimics a commodity index. We have one that is managed against the Dow Jones AIG Commodity Index. There are limited partnerships that follow the [Goldman Sachs Commodity Index]. I think people don't always use the discretion they need to when they establish their position. They don't always know what they're invested in. You could also buy a structured note [an instrument that provides exposure to an underlying asset like a commodity], which a lot of individual investors are starting to work with. That could give you protection on the downside and some participation on the upside over the next few years. You could buy basket of individual stocks. You could sell puts with the intent to buy some of these stocks at lower prices. There are so many different ways you could touch this space.