Newspaper article Sarasota Herald Tribune

How Commodity Investments Differ from Stocks and Bonds

Newspaper article Sarasota Herald Tribune

How Commodity Investments Differ from Stocks and Bonds

Article excerpt

HARRY MARKOWITZ'S DEVELOPment of "Modern Portfolio Theory" has led investors and their advisers to hunt for the best trade-off between investment returns and portfolio volatility. For most, this means careful allocations to the three main asset classes: stocks, bonds and cash. But some more adventurous investors are venturing into commodities.

Many investors are familiar with commodities such as gold, silver, oil, pork bellies and grain. Few understand, however, how to invest in them, the pros and cons of such investments and how they differ from investments in stocks and bonds.

Few investors invest directly in commodities. They generally invest either directly or indirectly in commodity futures. These are derivative securities that are essentially a short-term wager on the future value of a commodity. Indirect investments in commodity futures are available through exchange-traded funds or notes, sector mutual funds and limited partnerships called managed future pools.

It's also possible to invest even more indirectly in commodities, for example, by buying stock in a company that produces the commodity.

Commodity futures are unlike stocks or bonds. Recall that the purpose of stocks and bonds is to raise money for the corporation to then invest. A bond can be valued by examining its interest rate and its probability of default. A stock can be valued on forecasts of its earnings and dividends. These are all uncertain, and investors are paid to bear this uncertainty.

The purpose of commodity futures is quite different. Their purpose is to allow firms to buy insurance against the future value of the commodity. There is nothing to value -- no earnings or dividends or interest payments. Investors are simply betting on the short-term price fluctuations of the commodity and are being paid to bear that risk.

The simplest and easiest way for investors to add commodities to their portfolios is through commodity index mutual funds or exchange-traded products (ETPs). The latter trade on a stock exchange, just like any stock, and the former trade just like any mutual fund.

Aside from ease of entry, they have other advantages, such as low management fees, at least for ETPs, and high correlation with the price fluctuation of a commodity or market basket of commodities. …

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