A Case for Investing in Stuff

So you've assembled a well-balanced mix of investments, spread among stocks, bonds and money-market funds. But do you own any sugar? Cattle? Zinc?

From silver to soybeans, commodities are booming -- or at least they were until a nasty correction in February. Behind the run-up: A surge in crude-oil prices, coupled with demand from developing countries for raw materials. China's building boom, for example, has helped boost the price of copper, used in wiring and plumbing, by 48% over the past year. Sugar has nearly doubled on increased demand from countries that use it to produce ethanol. The Dow Jones-AIG Commodity index, which tracks 19 products, has nearly doubled since 2001.

Research shows that commodities tend to rise over periods of almost 20 years -- and then decline over periods equally as long. "The five- to ten-year outlook is compelling, which is good for long-term investors," says MacKenzie Davis, co-manager of RS Global Natural Resources fund. "But we've seen prices rise so far, so fast, that expectations are lower three years out for some commodities."

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Commodities are often regarded as speculative, lose-your-shirt ventures that carry "a fair share of negative baggage," says Michael Francis, a financial adviser in Hartland, Wis. Raw materials are subject to abrupt price swings, so don't put more than 5% of your investments in commodities.

Lately, investors have seen the dark side. The Dow Jones-AIG index fell 8% in the first two weeks of February, as many hedge funds unloaded commodities. "We're seeing a big retracement of the positions hedge funds built up in the past year," says Frank Lesh, a futures analyst at Rand Financial Services in Chicago. "Commodities needed a correction, but we're still in a bull market."

Whatever the immediate prospects for commodities, many advisers suggest holding some to diversify your portfolio. The rationale is that a sprinkling of corn, copper and cotton can reduce the volatility of your overall portfolio. Commodities provide a natural hedge against inflation, and they rarely move in sync with stocks and bonds. "Essentially, commodities zig when your other assets are zagging, creating a smoothing effect," says David Darst, chief strategist for Morgan Stanley's individual investor group.

You can invest in commodities through a variety of methods. We describe three approaches below.

Commodity-tracking funds

With $11.5 billion in assets, the largest commodity-oriented mutual fund by far is Pimco Commodity Real Return Strategy. The fund seeks to track the Dow Jones-AIG Commodity Total Return index but tries to enhance the index's returns by also investing in inflation-indexed bonds. The fund's D shares (symbol PCRDX; 800-426-0107), available with no sales charge at some discount brokers, returned an annualized 19% over the past three years to February 1.

You can also invest in commodities through a new exchange-traded fund, which you can buy in small chunks. The Deutsche Bank Commodity Index Tracking fund (DBC) began trading on the American Stock Exchange in early February at $25 a share, and by the middle of the month it was selling for $22. The fund mimics the performance of the Deutsche Bank Liquid Commodity index. Annual fees of 1.9% are high, but Deutsche Bank says interest from the Treasury bills the fund holds should offset most, if not all, of the expenses.

Commodity stocks

If you're a traditionalist, you might prefer a fund that buys shares of commodity producers. T. Rowe Price New Era (PRNEX; 800-638-5660) is a solid choice. Charles Ober, who has run the fund since 1997, invests in a mix of oil and gas producers, mining firms and paper companies. The fund has about two-thirds of its assets in energy -- a sizable stake, but less than that of the average natural-resources fund. Ober says he's become "increasingly selective" as prices of natural resources climb. "One way or another, these commodities will come back down, but you can still do well with the right companies," he says. Over the past three years, New Era returned an annualized 38%.

Precious-Metal Plays

Gold recently hit a 25-year high of $575 an ounce before retreating to $540 in mid February and is up 53% over the past three years. Inflation fears and a shortage of global supply amid fervent demand from emerging countries for jewelry are behind the yellow metal's strength. Expect more volatility in gold prices in the coming year. "I'd nibble to get a little diversification in your portfolio, but be cautious of any asset that's had such a big multiyear upswing," says Morgan Stanley's Darst.

Two exchange-traded funds track the price of gold, each offering shares that represent one-tenth of an ounce of gold bullion. StreetTracks Gold Shares (GLD) and iShares Comex Gold Trust (IAU) are virtually interchangeable and both recently traded at about $54 a share.

Gold isn't the only precious metal posting glittering returns. The price of silver, which is used in jewelry and photography, rose 30% in 2005, and regulators are still currently considering an ETF that tracks the commodity.

You can also buy funds that own precious-metal stocks, but be forewarned that their volatility is off the charts. The top-performing precious-metal fund over the past three years was U.S. Global Investors World Precious Minerals (UNWPX; 800-873-8637), with an annualized gain of 45%. Over the past three years, this no-load fund, which mainly owns shares of Canadian miners, has been nearly four times more volatile than the overall U.S. stock market.