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Should You Add Commodities to Your Portfolio?

Most investors hold a mix of stocks, bond, and cash (the latter of which includes GICs and high-interest savings accounts). And over the past several years, many might have started to add commodities to the mix.

Nowadays, there are various exchange-traded funds (ETFs) linked to everything from oil to gold and even coffee. In short, if you can think of a widely used natural resource, there’s a very good chance Wall Street has devised a way for you to bet on it. Some of these ETFs allow you to own physical commodities, but many are just commodity futures (contracts tied to the price of the resource).

And there are lots of experts who will tell you to consider the likes of industrial metals, grains, and energy for your baskets of investments. Just Google the phrase “adding commodities to portfolio” and you’ll see plenty of articles and blog posts touting the merits of this strategy.

The case for commodities is essentially threefold.

First, proponents say that having commodities in your portfolio reduces the overall volatility of your investments. The argument here is that resources represent a so-called “uncorrelated asset,” meaning that when stocks go in one direction, commodities should go the other way.

Second, advocates for commodity investing point to studies suggesting that over many decades, owning commodity futures provides outsized returns.

Finally, commodity bulls point to the rise of China and India as a reason to own commodities. The industrialization of those two countries, in particular, is cited as a good reason to own tangible assets that will benefit from its growth.

So are these valid arguments? Should you buy a commodity ETF?

Let’s step back for a second. It’s important to realize that commodity investing for the public is a relatively new phenomenon. And it follows on the heels of a huge amount of speculative behaviour by large investors, such as hedge funds.

One of the implications of this is that to a large degree, commodity prices are now very heavily driven by the behaviour of investors (as opposed to real world supply and demand). Indeed, over the past 10 years, we have witnessed not one, but two giant commodity bubbles and crashes. The most recent collapse resulted in oil falling from more than US$100 a barrel to below US$30.

But how about the argument that owning commodities reduces the volatility in your portfolio? That may have been true before investors jumped into the sector en masse but when the 2008 crisis hit, both commodities and stocks plunged.

As for the argument that commodities provide outsized returns, again, that may have been true before they became a fad but that’s really no longer the case. (If you want to read about the technical reasons for this, read this Reuters article.)

How about China? It was growing at a rapid clip but now the question is really how fast it’s slowing down. It’s a country plagued with high debts and overcapacity and many experts feel it could be the focal point of the next financial crisis.

If we haven’t already warned you off commodity investing, there’s one more thing to know. If you’re a Canadian investor, you already probably have substantial exposure to the movements in commodity prices. Canada is a resource nation and it’s reflected in the TSX, our benchmark stock index. Energy and materials companies represent a substantial weighting (nearly 33%) of the market.

All in all, leave commodities to active traders and professionals. You may miss out on some temporary gains but when the next bust hits, you’ll be glad to stayed out.

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Flickr: Mark Herpel