How smaller investors can purchase commodities

OK, we get the idea. Having commodities as part of our portfolio can reduce risk by offsetting big swings in stocks and bonds. But how do we actually do it?

That was the gist of reader response to a recent column about reducing investment risk. The concept was fine, but I hadn't finished the story. I had said nothing about how investors with relatively small nest eggs could actually put a slug of commodities in their portfolios.

After the roller coaster ride of 2007, we'd all like to have a bit more stability in our investments. If you can reduce risk without reducing return, well, that's right up there with apple pie.

In fact, Craig Israelsen, the Brigham Young University professor who showed that adding commodities reduced portfolio risk, has offered a solution. He calls it "quasi-commodities" -- mutual funds that serve as proxies for commodities.

Examining the 20-year period from 1987 through 2006, he found that a mixture of Vanguard Energy, Fidelity Real Estate, and Vanguard Metals and Mining improved the return of a typical stock and bond portfolio while reducing risk. It also provided an improved return and reduced risk compared to a conventional portfolio with a Goldman Sachs Commodities Index component.

For the record, there can be lots of quibbling about this solution.

Modern portfolio theory purists, for instance, would complain that commodities shouldn't be considered. They aren't an earning asset class. Treasury bills, bonds and equities of all kinds are assets that earn. Commodities, on the other hand, don't earn. They simply grow (or shrink) in market price. Over a long period of time the price of commodities has barely kept up with inflation.

Gold is a good example. It was a great speculation in 1977 when its price soared from $77 an ounce to more than $800 an ounce by 1981. But cash held in gold was dead money for the next 26 years -- its price exceeded $800 only in the fourth quarter of 2007.

Purists would also say that investing in energy stocks, real estate stocks or mining stocks is just investing in sectors of the equity market. So it is neither commodity investing, nor is it asset-class investing.

Commodity enthusiasts, on the other hand, would argue that it is better to own futures contracts than to own shares of companies that produce commodities. Reason: They expect commodity price inflation in the future. Periods of price inflation tend to hurt equity valuations, so you won't get the full benefit of rising commodity prices by investing in the companies that produce them.

Is there a final word on this?

Sorry, no.

Lack of agreement on theory, however, shouldn't dampen the good news about practical investing. The growth of index investing, particularly in the burgeoning exchange-traded index fund market, has made it possible for small investors to build portfolios that take either path, the quasi-commodity path suggested by Israelsen or direct investment in a fund that tracks a commodity index.

A simple quasi-commodity portfolio solution can be found in the Couch Potato Building Block portfolios on my Web site, www.scottburns.com. The original Couch Potato portfolio (50 percent domestic total market/50 percent TIPS) provided a return of 8.34 percent for 2007. The Margarita portfolio, which adds the broad international EAFE index, returned 8.88 percent. Those are conventional asset-class portfolios.

The Six Ways From Sunday portfolio, however, includes a REIT index and an energy index. It returned 9.15 percent for 2007. Significantly, the continuing surge in energy stocks (up 34.9 percent in 2007) completely offsets the loss in REITs (down 16.5 percent in 2007), yet another indication that broad diversification helps to smooth your ride.

Another option is to invest in one of the exchange-traded funds that duplicate a commodity index. Three broad commodity index ETFs are: (1) iPath Dow Jones AIG Commodity Index Trust (ticker: DJP), (2) iShares S&P GSCI Index Trust (ticker: GSG), and (3) Powershares DB Commodity Index Tracking Fund (ticker: DBC). All three have expense ratios of 0.75 percent. This makes them expensive additions to an index fund portfolio. Also, as commodity investing guru Jim Rogers has pointed out many times, the Goldman Sachs commodity index is very heavily weighted with energy, so it's more an energy index than a commodity index.

© 2008, Universal Press Syndicate