Diversify Your Portfolio with This Kiplinger 25 Fund

It’s no secret that prices of commodities -- from grains to oil to precious metals -- have been on a roll. Pimco CommodityRealReturn Strategy (symbol PCRDX) has done even better. Over the past year through January 20 the fund, a member of the Kiplinger 25, gained 23.2%, five percentage points better than its benchmark, the Dow Jones-UBS Commodity Total Return index. Over the past five years, the fund returned 2.7% annualized, compared with 1.0% annualized for the index (the results of both were dragged down by big losses during the financial crisis).

The fund’s manager, Mihir Worah, adds value mainly by skillfully investing the collateral that backs the funds’ positions in commodity-futures contracts. Worah invests the bulk of Commodity’s collateral in Treasury inflation-protection securities, or TIPS. However, Worah, who also runs Pimco RealReturn (PRRDX), one of the better funds focusing on TIPS, recently moved some of the money in the commodity fund out of TIPS and into high-grade-corporate floating-rate notes and foreign currencies (interest rates on the former reset with changes in short-term rates).

Worah anticipates a much more modest return from commodities in 2011 than in 2010, when 17 of the 19 commodities in the DJ-AIG index registered gains (natural gas and zinc were the only losers). For example, the surge in grain prices last year owed much to a drought in Ukraine and lower-than-expected yields in the big U.S. corn crop. Floods in Pakistan wiped out that country’s cotton crop, helping cotton prices to spike.

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Worah is lukewarm on gold. He expects interest rates to rise this year, and that would make the yellow metal less attractive to investors. We could see $100-a-barrel oil prices, he says, but “not much beyond that since then it kills its own demand” (light crude oil currently sells for $90 a barrel). On the plus side for gold and oil, he notes, is that both are being used as hedges against potential declines in the U.S. dollar and the euro.

Of course, neither Worah, who holds a doctorate in theoretical physics from the University of Chicago, nor anyone else is able to divine this year’s weather in the grain belts, looming mining or oil-rig disasters, or geopolitical instability in hot spots such as the Persian Gulf.

But what we do know is that commodities provide good protection against spikes in inflation and currency weakness. Their prices overall tend not to move in sync with stocks and bonds, making commodities useful for diversifying a portfolio. In Worah’s opinion, investors should have at least 5% of their investments in commodities (but not more than 10%).