how (and how not) to invest in commodities

So you’re bound and determined to add commodities to your portfolio, and for all the right reasons. Great! There are a few ways to do it…though I would only strongly recommend one.

Buy the commodities themselves. Stocks and bonds are quite liquid, since they’re essentially notes saying “you own X” or “we owe you X”. Commodities, much less so. Sure, you can buy gold coins, but to buy enough that they’re a substantial part of your portfolio — not to mention diversifying into other commodities such as timber — would get prohibitive very, very quickly.

Buy GLD. Purchasing a share of the SPDR Gold Trust ETF (“GLD”) entitles you to ownership of a piece of the gold held by the trust in reserve. You could even redeem a “basket” (100,000 shares) for the equivalent in gold, if you so desired. This is much more liquid than buying gold bars themselves, but in buying gold you’re holding a concentrated position in one particular commodity — one which has historically shown itself to be among the most volatile!

Buy precious metals equities. That is, buy stock in mining companies. This isn’t a terrible idea, as precious metals equities tend to be relatively uncorrelated to other equities and positively correlated with inflation, both of which are good for hedging, and you can buy a low-cost, diversified bucket of them via Vanguard’s VGPMX fund. However, like GLD, VGPMX is highly volatile, and its returns have not had nearly the sharp upward trend that GLD has had over the past decade.

Buy a collateralized commodity futures (CCF) fund. This sounds a little complicated, and it is — a little. A CCF doesn’t buy commodities, but rather it buys futures — contracts to buy commodities at a future date at a certain price. Moreover, the cost of buying the contract is a small fraction of the cost of the commodities themselves; the rest of the collateral can be invested in a high-quality investment like treasury bills or TIPS, which earns interest during the time of the contract. (Of course, the fund never actually buys the commodity, but rather keeps rolling the futures forward indefinitely.) What this means is that by investing in a fund like PIMCO CommodityRealReturn, you can double-hedge against inflation — once by the price of commodities, and again by the TIPS used as collateral. PCRIX is well-diversified and has a not-terrible expense ratio, to boot. You’re still not going to earn much more than inflation in the long run, but a dollop of this in your portfolio can reduce inflation-related volatility without sacrificing too much in the way of returns.

As you’ve guessed, I can really only recommend CCF’s, and even then only if you’re committed to investing in commodities. It may be comforting to invest in something that is “real”, but just because something is tangible doesn’t mean that its value doesn’t fluctuate as much — or even more — than something that is intangible! (And if you want to invest in something that’s exciting…well, I can only hope that you’re limiting your gambling addiction to a small fraction of your portfolio.)