Commodities and Natural Resources

Financial-Planning.com June 2011 article by Donald Jay Korn quotes Rick Ferri, founder of Portfolio Solutions, stating that "...for exposure to commodities and natural resources...many investors need look no further than their own equity portfolios...".

This reminds me that there is also a lot of exposure to international economies in those same equity portfolios. For example, many U.S. companies of all sizes, are multi-national and derive significant income from beyond the borders of the U.S.

Look at that exposure to international, commodities and natural resources when evaluating your portfolio fund selections.

Commodities - an Alternative Investment

Commodity funds are considered an alternative investment to bonds and stocks. Though only a small portion of your total portfolio should be invested here, before investing, it is important to understand the terms contango and backwardation.

Many commodity funds purchase limited time period futures contracts and as they expire, the money is rolled forward to the next contract. Investors lose money when expiring contracts are rolled into higher cost future contracts. That is actually common and this is why some commodity funds lose money as the price of the commodity goes up.

Backwardation occurs when those future contracts are priced less than the current expiring contract.

High-priced commodities may purchase the actual item, like some precious metals (gold, as an example), and avoid the futures contracts altogether but if you do not understand these concepts then I would fully understand them first before investing in them. Know what your fund strategy is and how it works.

There are some commodity futures funds that rotate and shift their weightings based on the "roll yield" to help minimize the effects of contango. They are relatively new and it remains to be seen if the strategies used will be effective.

Foreign Corporate Bonds - Another Alternative

If investing in foreign currencies as an alternative investment is too difficult to understand and implement, then investing in foreign coporate bonds may be another method to diversify a portfolio.

The disadvantages are many: political risk, interest rate risk, higher volatility, lack of standard reporting from companies, etc. and so selecting the appropriate vehicle and minimizing exposure are essential.

 

Commodities - An Uncorrelated Alternative or Are They?

Commodities may have been less correlated with stocks in the past (1970's and 1980's) because there was a lot of spare capacity. This allowed for price gyrations independent of stock returns. In the past, large positive returns were compacted into only a few years making the long-term averages higher. Those few high years of commodity returns offset many years of returns that were below the stock averages.

Is is possible that, as Virginia Munger Kahn writes in the August 2011 issue of Financial Advisor magazine, that, "...while supply shocks can still send commodities soaring and equities reeling, commodities and equities now march to the same drummer - global economic growth..."?

If so, the diversification benefits that many investors are seeking in commodities may not be as helpful as in the past. I tend to agree.

Bond Alternative: Emerging Market Bonds

I hear some advisors considering investments in bonds in other markets besides the U.S.

U.S. bonds may be backed by the good faith and credit of the U.S. government (a subject of concern by some in and of  itself) but when investing in bonds outside the U.S. there are several additional risks. The main one, besides political risk, is the currency volatility which may be much more than the bond price/yield changes.

Some consider bond investments in emerging markets as speculation so fully understand them not as a bond investment but as a risky alternative investment to stocks, bonds, real estate and cash categories.

Frontier Markets - 9 Risks

Emerging markets (like China, India, Russia, Brazil) are bigger in comparison to the Frontier Markets. This includes 29 countries like Vietnam and Argentina.

Risky, yes.

Here are nine possible risks to consider:

• Corrupt governments
• Few public companies
• One industry
• Export-driven
• Lack basic processes
• Illiquid (small markets)
• Inefficient (could be a good thing)
• Local investors drive prices
• Low correlation to other markets (again, could be a good thing but still a risk)

Definitely an alternative type investment.

ARO: Absolute Return Oriented Funds

I mentioned in a previous blog entry about this concept of "absolute return" and how enticing it sounds. Keep in mind the following:

1) Lack of historical performance (and no idea how they will perform in the future but I guess all investments have that issue to some degree)

2) Complex strategies (if you cannot understand the short-selling and hedging going on then do not invest; stocks go up more often than they go down)

3) Limited benchmarks (so how do you compare your absolute-return fund to others? There are plenty of indexed funds around to compare with your stock and bond funds)

What are Alternative Investments?

Alternative investments are financial vehicles outside of stocks, bonds and cash. Here are some examples:

(1) Long-short funds (shorting a segment of the market means betting that an item will go down when 68% of the time they go up)
(2) Bear Market funds (expecting markets to go down, not up, the odds are against you unless you know ahead of time)
(3) Currency trades
(4) Managed future contracts (commodities-related with hedging strategies)
(5) Hedge funds (often expensive with 2% expenses and 20% share in profits)
(6) Merger/Arbitrage funds
(7) Distressed Debt
(8) Structured Notes

and, my favorite (just teasing):
(9) Absolute Return funds (sorry, no guarantees)

Do you need them? Most investors and those that work with me do not. Besides, many Errors & Omissions (E&O policies) do not cover these alternative investments without extra costs.

Alternatives to stocks, bonds and cash that may be useful, depending on your circumstances, might include:

(1) Real Estate Investment Trusts (REITS)
(2) Emerging Markets
(3) TIPS = Treasury Inflation-Protected Securities (though, I have my doubts about whether the CPI (and therefore TIPS) is a good measure to base your own personal inflation rate)

Foreign Currency Investments

One alternative type of investment to stocks, bonds and international securities is investing in currencies of other countries. The cheapest and easiest method is through Currency ETF's provided by Barclays, Powershares, Rydex and Wisdom Tree as examples. Should you?



Institutional investors use these tools for short-term, strategic and/or tactical purposes but not so much for long-term "buy-and-hold" investing.



One reason to invest in foreign currencies is that they are not correlated with your other financial assets (so they may go up or down regardless of whether the Dow Jones is going up or down).



But...here is an argument against:



...if you already have investments in large U.S. companies that obtain 50% of their revenues from overseas and you also have investments in international stock and bond funds, then you have exposure to foreign currencies already.



If you have decided to invest 5%, for example, directly in foreign currency investments and experience a positive change in that fund, this may be more than offset by your other international holdings going negative.



Yes, this is what negative, low or no correlation does for your overall portfolio but it may make little sense unless you calculate how much of a percentage in foreign currencies is needed to truly offset your international positions.



Here is a better argument for avoiding foreign currency investments (from Financial Advisor magazine, February 2010 issue article "Taming the Currency Elephant" by Marla Brill):



"...simply that over long periods, currency moves tend to even out. Since it has been argued that long-term expected returns are essentially zero, a currency overlay for long-term holdings [buy-and-hold investors] would seem to make little sense..." I agree.



I am not alone, "...at the beginning of December, currency ETFs held some $6.3 billion in assets..." compared to an "...average daily turnover of $3.2 trillion...", so you can see that "...the daily currency turnover is more than ten times that of all of the world's equity markets combined..." The activity is high but the ETF participants are pretty insignificant (of-course there are other ways to participate). Just keep perspective, as I often say/write.