How to Invest in Commodities—and Why You Should

For the first time since 2010, commodities are showing signs of life. So far this year, a diversified package of commodities is outpacing both the stock and bond markets. But if you hold some of these basic materials in your portfolio—or are tempted to get back in now—you’ll want to be careful about how you ride the turnaround.

See Also: Watch Out for Overpriced Stocks

Beyond improving performance, there are two good reasons to hold some commodities—or, to be more precise, investments that track the price of commodities. Diversification is one. Research shows that commodities typically don’t move in sync with stocks and bonds, and that’s holding true now. Year to date, the Dow Jones-UBS Commodity index, which tracks 20 commodity markets, including corn, gold and oil, has gained 7.9%, whipping the return of Standard & Poor’s 500-stock index by 5.3 percentage points and the Barclays U.S. Aggregate Bond index by 4.5 percentage points (all returns are through May 22).

Commodities can also act as a type of insurance policy against sudden spikes in the price of goods. Inflation in the U.S. has been tame lately, but severe weather and political events have helped push up prices of certain raw materials. For example, the Indonesian government’s decision in January to halt nickel-ore exports propelled the price of the metal (which is used to make stainless steel) to a gain of more than 40% so far this year. And a drought in Brazil, the world’s largest coffee producer, has helped lift the price of arabica coffee by more than 80% since November. Some commodities also serve as safe havens against geopolitical uncertainties. From the beginning of the year through mid March, when the Russia-Ukraine standoff reached a crescendo, gold climbed 13%.

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But commodity prices are notoriously volatile, and other trends could serve to keep a limit on prices and maybe even drive them down. One development to watch is slowing growth in China, a major importer of raw materials. Gold in particular is known for having long boom and bust cycles, and as the U.S. economy improves, fewer investors may seek out the yellow metal as a safe haven. After rallying in the first ten weeks of 2014, gold, at $1,294 per ounce, has fallen 7% since mid-March. Paul Christopher, chief international strategist at Wells Fargo Advisors, believes the price could tumble to as low as $1,200 by the end of the year. “We’ve been advising clients to start unloading,” he says.

All of which suggests the road ahead for commodities could be bumpy. Chris Philips, a senior analyst in the investment strategy group at Vanguard, says it’s a good idea to keep 5% to 10% of your portfolio in commodities—but only if you’re willing to hold on for the long term. That may be easier to do with a mutual fund or exchange-traded fund that invests across multiple commodities markets. If you bet on a single commodity, you stand a good chance of getting spooked and selling at the wrong time. Recently, Vanguard studied the gains investors earned in SPDR Gold Shares (GLD), the largest ETF that tracks the price of gold. Vanguard found that from November 2004 (when the fund launched) through February of this year, investors earned an average of 3.2 percentage points per year less than the fund’s stated return, mostly because of poor timing decisions. (Investors tended to bail out after prices fell and buy in long after a rebound had started.)

Four Great Commodities Investments to Consider

Most commodities funds and ETFs own futures contracts (an agreement to buy or sell a commodity for a set price at a future date). Futures contracts are easier to own than the physical commodity, which must be stored somewhere (and perhaps fed as well). But because of quirks in futures trading, fund performance does not always match that of the underlying commodity. To get around that, some funds buy contracts with varying maturities (rather than just roll over contracts from month to month as they expire, which is what usually happens).

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Harbor Commodity Real Return Strategy (HACMX) is one example of a fund that has done this successfully. The mutual fund, which mirrors the Dow Jones-UBS Commodity index, returned an annualized 6.5% over the past five years. That beat 85% of the funds in its category, according to Morningstar. Reasonable fees also help. The fund charges just 0.94% annually, compared with an average of 1.34% for its peer group.

Real Return provides an additional buffer against inflation by buying Treasury inflation-protected securities with the cash it doesn’t use to purchase futures contracts. In 2013, when the risk of rising interest rates sent bonds packing, Real Return plummeted a staggering 14.9%. But manager Mihir Worah has since shortened the average duration (a measure of a bond’s sensitivity to changes in interest rates) for the fund’s TIPS. And so far this year, Real Return has gained 10.1%.

Exchange-traded PowerShares DB Commodity Index Tracking (DBC) also buys futures, in its case to track an index of 14 commodities that are weighted based on the economic heft of the good (measured by how much of the commodity is produced and stored globally). The approach is akin to weighting stocks in an index based on company market values. Year to date, DB has returned a meager 2.9%, lagging its index by more than a quarter of a percentage point. But DB also has a record of coming out ahead in down periods, including in 2012, when the fund gained 3.5% and its average peer fell 0.5%. The fund charges annual fees of 0.85%, about average for commodity ETFs.

GreenHaven Continuous Commodity Index (GCC) takes a different approach to assembling its portfolio. Unlike most of its peers, the ETF does not follow an index with a type of market-weight strategy. Instead, it tracks an index that equally weights futures contracts for 17 commodities. Equal weighting gives sectors with a smaller economic punch, such as agriculture, more influence over returns. GreenHaven struggled during most of the past three years, but it has returned 11.9% so far this year. It has also done a good job of tracking its index.

One final option worth mentioning: Elements Rogers International Commodity (RJI). This is an exchange-traded note, which is essentially a debt instrument that promises to give you the return of an index. As such, when you invest in an ETN you take on the credit risk of the lender. But Rogers is issued by an agency of the Swedish government, which carries the strongest rating of any ETN issuer, according to Morningstar. Rogers provides exposure to a whopping 37 commodities, making it one of the most broadly diversified of its peers. From 2008, the ETN’s first full year, through 2013, it landed in the top half of its category each year. Annual fees are 0.75%.