Real assets: the role of commodities in investment portfolios.

• Author: Humphreys, II, Edward
• Position: ADVICE: INVESTMENTS

WHEN THE WORD "commodity" is mentioned in conversation, some may think of speculation in pork bellies or gold futures. However, commodities are the raw materials producers use to manufacture the goods we buy and the food we eat.

Adding commodities to a diversified investment portfolio of stocks and bonds provides several benefits for an investor, including positive returns over time and negative correlation to financial assets, such as stocks and bonds.

One approach to investing in commodities is to invest in a mutual fund that tracks the Dow Jones American International Group Inc. (DJ-MG) Commodity Index, which provides exposure to a basket of commodities, including energy, livestock, industrial metals, precious metals, grains and food/fiber.

As an asset class, commodities have exhibited long-run positive returns that often equal or exceed the long-term returns of stocks with comparable risk. The returns of commodity indexes come from three major sources: spot returns, rebalancing returns and interest yield on collateral.

Commodity prices tend to rise over time. Many of us can remember 80-cents-a-gallon gasoline and nice, four-bedroom houses that cost $70,000. Investing in commodities allows the investor to take advantage of this upward movement in prices of real assets, thus protecting an investment portfolio from inflation. In addition, recent demand from developing nations has driven the price of most commodities even higher.

Another source of return comes from the rebalancing of the sectors within the DJ-AIG Commodity index. Commodities have a tendency to "mean revert." For example, as corn prices go up because of demand for corn-based ethanol, more farmers will plant corn vs. other crops, such as soybeans. The result will be an increase in the supply of corn, which drives the price down towards its long-term average.

In the meantime, soybeans may go up in price as there are now fewer farmers planting them. Therefore, through active rebalancing, a commodity index can increase in value even if the sectors within the index do not gain in value over time.

Another unique feature of commodity investing is the ability to earn interest on the collateral used to purchase the commodity future contract. Unlike...