The Hard Facts, Part 2

As we first discussed in last week's column, adding hard assets to a portfolio has historically increased its return while lowering its overall risk. This is because hard assets are generally noncorrelated with financial assets. When the stock market zigs, they tend to zag.

Last week we focused on real estate as one component of an allocation to hard assets. This week, we'll focus on commodities.

We live in a world of limitless duplication, where fax machines, copiers and email can transmit a million messages just as easily as one. That's not the case with commodities, which are, by definition, scarce resources. We can't just .pdf a wheat field so that everyone can bake brownies or mass email crude oil so that everyone's tanks are topped.

During inflationary periods, this adds up to strong outperformance by both commodities and the companies that deal in them. In the 1970s, for example, returns on stocks, bonds and other financial assets were consistently topped by those related to hard assets. Although today they'd seem woefully outdated and a bit on the paranoid side, an investor in 1980 looking to put money into the best-performing assets would've chosen investments such as gold, silver, diamonds and farmland.

Historically, hard assets have included agriculture, metals (both industrial and precious), energy and livestock. Although for our purposes we'll focus on the most traditional commodities, a broad definition would also include collectables — items like ceramics, jewelry and even wine. In fact, a new wine futures contract recently launched in France (where else?) lets you go long or short a basket of Bordeaux.

Given the evidence in favor of allocating a portion of your portfolio to hard assets, the real question isn't if you should, but how you should. As we like to point out, successful trading is more a function of how you buy than what you buy. Selecting the asset class is one step, but picking the appropriate instrument is another thing altogether. It's tougher than it seems. While there are a number of ways for large institutions to get exposure to commodities as an asset class, there are only a handful of ways the individual investor can participate.

The most obvious way to allocate money to commodities is to buy them directly. Of course, storing large quantities of grain or oil is impossible for most people, and even small positions in precious metals are cumbersome to own and profit from. Even if gold prices double, for example, chances are that a one-ounce gold bracelet won't have a big impact on your bottom line. To profit from commodities, you've got to own a lot of 'em, which makes buying derivatives — some more leveraged than others — a much more effective tool than filling your sunroom with soybeans.

The most direct and leveraged way to invest in commodities would be to buy futures contracts, which have long been traded on a variety of commodities. For smaller speculators, trading these instruments has become much easier thanks to the recent development of "mini" contracts designed for individual investors. Just like the popular E-Mini S&P 500 or E-mini Nasdaq futures contracts, smaller versions of a number of popular physical commodities like wheat and soybeans are available to more sophisticated investors with futures accounts.

Among the commodities not represented with a mini-futures contract is crude oil, which is probably the one to which majority of us have the most exposure. After all, when crude oil rises, so does the price of gas at the pump. One direct way to go "long" crude oil is through a unique structured product traded on the American Stock Exchange. J.P. Morgan Commodity-Indexed Preferred Securities (JPW) tracks the performance of the JPMCI Crude Oil Total Return Index. Think of it as an exchange-traded fund for crude. If oil prices rise, so will the price of JPW. Besides being nondiversified, the two main drawbacks are the lack of liquidity and the fact that JPW will "mature" (and thus stop being traded) in March of next year. The American Stock Exchange has yet to announce whether a similar security will be listed after that time.

Another direct play on hard assets are shares of forestry company Plum Creek Timber (PCL), a real-estate investment trust whose primary asset is more than 3.2 million acres of timberland. Uncorrelated with all the major indexes and recently called a Buy at Salomon Smith Barney, Plum Creek's shares have performed well of late. They're up 10% year-to-date and yet still offer a dividend yield of more than 8%.

Most investors realize that they can mitigate company-specific risk by investing in a broad index product, such as an S&P 500 ETF. Similarly, exchanges have created a number of broad based commodity indexes to give investors a more diversified exposure to the asset class itself. The CRB Futures Price Index, the Standard and Poor's Commodity Index and the Dow Jones/AIG Commodity Index all track diversified baskets of various commodities. But these products are, for all practical purposes, too large for most individual investors. For example, the approximate size of one Standard and Poor's Commodity contract is $85,000.

One notable exception, however, is the Oppenheimer Real Asset fund (QRAAX), one of a handful of mutual funds that offers a diversified way to invest in commodities. While the manager is given some element of discretion, the fund is essentially focused on tracking the Goldman Sachs Commodity Index, which contains 26 components from all commodity sectors.

But be warned: The GSCI is largely slanted toward energy. More than 60% of its components are energy related, including items such as crude oil, heating oil and natural gas. Meanwhile, agriculture — including corn, cocoa, soybeans, wheat and others — accounts for less than 20% of the index, while precious metals make up less than 3%. As a result, the recent strength in commodities like cocoa and sugar has had virtually no impact on the index. Thanks to a dramatic drop in oil and natural gas prices, the fund is down more than 25% year-to-date. Over longer periods of time, however, it has held up remarkably well. According to a 1998 Ibbotson Study, during the 28-year period from Dec. 31, 1969 to Feb. 28, 1997, the Goldman Sachs Index rose at a compound annual rate of 13.7%, beating both the S&P 500 (12.5%) and Treasury bonds (9.2%).

If you can't buy commodities themselves, another strategy is to invest in the companies that deal in them. The Morgan Stanley Commodity-Related Equity Index has outperformed the Dow, Nasdaq and S&P over one year, two years and three years.

Hard Assets in Hard Times
Source: Asset Allocation by Roger C. Gibson (McGraw Hill)

With that in mind, another fund to consider is the Van Eck Global Hard Assets fund (GHAAX). Unlike the Real Asset fund, whose performance is largely linked to the underlying commodities themselves, the Van Eck fund, like a number of natural-resource funds, buys the stocks of various commodity-related companies. Thanks to an overweight position in gold-mining shares, the Van Eck offering has outpaced most other natural-resources funds this year, although it's still down 13%.

While there are more than 10 ETFs that hold tech stocks, there's but one ETF that invests in natural-resources companies. Although it's a promising start toward a truly diversified commodities-based ETF, the recently launched Goldman Sachs Natural Resources Index Fund (IGE) suffers, like many other commodity-related products, from the dominance of energy components. More than 60% of the index is held in companies like BP (BP), Exxon Mobil (XOM), Royal Dutch Petroleum (RD) and Chevron Texaco (CVX). Agricultural issues are excluded from the portfolio altogether.

The research definitively shows that hard assets, when held over time, not only increase a portfolio's return but can reduce its risk as well. Until the exchanges offer retail-sized ETFs based on popular commodity indexes, the best way for most investors to play hard assets will be via the handful of mutual funds that invest in hard assets. From a contrarian perspective, the lack of interest and enthusiasm for investing in these products, coupled with the absence of product offerings, might suggest that inflation isn't dead at all but is merely lulling traders to sleep, patiently waiting to make its inevitable return.

Jonathan Hoenig is portfolio manager at Capitalistpig Asset Management, a Chicago-based hedge fund.