It's also tempting to want to position your portfolio to benefit from price gains in commodities. If you're going to have to fork over more cash to fill up your petrol tank and your kitchen cupboards, why not try to earn back at least some of those extra costs by owning commodities or the companies that sell them?
Commodities: Time to Wade In?
So, should you join the throngs flocking to energy and commodities? Recent returns have certainly been scorching: As worrisome signs about inflation and the strength of the global economy have been drag
ging down the broad market, commodities, energy, and basic-materials securities have been a rare bright spot. For the five years ended 16 July, the S&P/GSCI Commodity Index gained 16% per year on average, versus a 9% gain for the FTSE All Share and a 6.7% rise for MSCI World. Further, there is little performance correlation between commodities and major indexes--the FTSE All Shares correlation with the S&P/GSCI Index over the past 5 years is just 0.14, a minuscule level (1 would indicate perfect correlation; for context, the All Share has a correlation of 0.89 with the MSCI World index). So, commodities clearly are a worthwhile diversifier as a small part of a long-term portfolio.
Nonetheless, the contrarian in me gets very nervous when investors stampede into any asset class, whether it's technology stocks, China equities, or property. I'm not about to call a top in commodities, but I can't help but wonder whether the smart money has already been made. It also makes me nervous that hedge funds, some of them betting with borrowed money, have been among the biggest investors in commodity-related investments. Should they start reversing their bets or be forced to sell securities to meet redemptions, the fortunes of commodities and commodity-related stocks could take a hit. Finally, it also stands to reason that rising prices, at some point, will tamp down demand for energy and basic materials.
Commodities: Look Before You Leap
An even bigger reason to be cautious about adding energy- and commodity-related investments at this juncture is that you may well already have a fair amount of exposure to these areas already. Even if you don't own a commodities fund that specifically tracks commodity-price performance, if you own any equity funds, you're likely to own shares of public companies that extract and distribute commodities. Indeed, the FTSE All Share had roughly 30% in commodity-related issues at end of May.
Even if you've not added dedicated energy and basic-materials stock exposure, it's a good bet that some of your fund managers have. Managers from across the value/growth spectrum have been adding to their stakes in energy and basic-materials stocks over the past few years. Even a tack of benign neglect would have resulted in a higher energy-stock stake, owing to the sector's massive appreciation since 2002. The FTSE All Share's metals & mining exposure has more than doubled in the past three years alone, and companies such as Royal Dutch Shell (links will open in a new window), BP, Rio Tinto, and BHP Billiton are prominent portfolio holdings for many managers.
You may also have compounded your exposure without knowing it by adding to your winners. If you own a fund that has performed markedly better than your other holdings over the past few years, chances are that fund has a fair amount of exposure to energy and other basic materials. Ditto if you are among the legions of investors who have bought or added to an international, global, and/or emerging-markets fund over the past several years. Several of the fastest-growing international markets, ranging from India to Brazil to Russia, owe at least part of their recent success to spiking demand for oil, metals, and other basic materials. (Many of these economies happen to have rich reserves of commodities.) In fact, energy stocks currently account for about 18% of the MSCI Emerging Markets Index, and some of the more aggressively positioned funds hold an even larger stake than that. The "Industrial Materials" sector, which houses basic-materials companies as well as manufacturing firms, accounts for another 20% of the index.
Commodity Exposure & Your Portfolio: Find Your Baseline
One starting point for gauging how much exposure you have to such securities is to use Morningstar's Portfolio Manager or Instant X-Ray to check up on your portfolio's current positioning. If you haven't yet entered your portfolio into our Portfolio Manager tool, Instant X-Ray is one of the easiest ways to do so. Simply enter the investment amounts and names for each of your holdings, then click Show Instant X-Ray. You'll be able to see your portfolio's stock/bond/cash mix, as well as your investment-style and sector positioning. You can then compare that sector positioning with that a benchmark of your choosing (use the drop-down menu at upper right to select a benchmark).
True, owning a lot in energy and industrial-materials stocks isn't the same as owning an index fund that tracks actual physical commodities. But if your exposure to those sectors is high, that should set off alarm bells about adding commodities at this juncture. And in any case, those looking to add a dedicated commodities fund shouldn't do so expecting overnight riches but instead should consider it part of a long-term asset-allocation strategy.
