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Commodities: The Tipping Point?

Some players may think the boom in energy, metals, and food is rewriting the rules of investing. Don't bet your portfolio on it

As oil ascends above $140 per barrel, the hot—some say overheated—commodities market has become Topic A on Wall Street and Main Street.

Lawmakers worry about manipulation and excessive speculation. Market participants debate the pros and cons of government regulation, and worry that a speculative bubble is forming in key commodities like oil. Meanwhile, consumers feel the pinch as they pay much more for food and energy.

But investors face their own commodity dilemma.

In the past year, investing in commodities has provided healthy returns while stocks, bonds, and other investments have been stagnant or dropped in value.

Many investment advisers have spent the past several years steering small portions of portfolios—often 3% to 5%—into commodity index funds. Commodities offered a way to reduce risk in a portfolio, they argued. Commodities can protect against inflation and move independently of other investments, often gaining value while stocks or bonds fall (or vice versa).

As a result, pension funds, hedge funds, and individuals began to pour money into the commodities market, first in a trickle, then in a steady stream, and now in a torrent. One favored vehicle: exchange-traded funds (ETFs) that track a broad array of commodities. According to TrimTabs Investment Research, more than $38 billion is now held in commodity ETFs, up more than 30% in the past five months.

Some Drawbacks

But investors are also starting to realize the popularity of the commodities has its drawbacks.

For one thing, says Susan Elser of Elser Financial Planning in Indianapolis, "commodities have become a highly volatile investment class."

Most of Elser's clients are in their late 50s or older, and she's not willing to put their retirement nest eggs in an investment category prone to wild swings from month to month. Market participants disagree on whether speculators are to blame for the current volatility. But there's no doubt that if oil can rise 40% in the first seven months of 2008, it can just as easily fall by a similar percentage at some point in the future.

Another problem with commodities is they are a poor fit for investors saving for the long term.

For one thing, the forces pushing commodity prices higher can change direction. Keith Hembre, chief economist at First American Funds, says the flow of investing dollars may be lifting prices somewhat, but the "underlying strength" of oil and other commodities is rapid economic growth in emerging markets. Low interest rates in those overseas economies have added to the demand, and sparked worries about inflation worldwide.

"Ultimately what will put a cap on prices is a tightening of monetary policy globally, particularly in emerging markets where the primary source of demand has been," Hembre says. If overseas central bankers don't raise rates, the U.S. Federal Reserve may be forced to hike interest rates instead, pushing the U.S. into a deep recession that would in turn slow down world growth and commodity demand.

Long-Term Returns

At some point, the commodities boom will stop, and this points to another drawback to investing in commodities: The healthy returns for commodities of the last few years have been unusual. Commodities can often go for years or decades offering investors weak or negative returns.

Over the long term, "the expected return of a commodity is really zero percent," says Avani Ramnani of Athena Wealth Advisors in Jersey City, N.J. And that's before investors subtract transaction costs.

Unlike shares in a corporation that can grow and grow, or a bond that pays out interest each year, commodities are subject to the laws of supply and demand: In past commodity booms, higher prices have eventually cut into demand or spurred more supply. Prices didn't keep rising forever—they eventually stabilized or even fell.

"This whole trend of moving money into the commodities market, I don't think it's a healthy thing for individual investors," Ramnani says. An allocation to commodities does "lower the risk" of a portfolio, she says, "but it lowers the return as well." For investors putting away money for the long haul, "it doesn't serve any purpose," she says.

Political Backlash

One more danger for commodity investors may be the hardest to predict: Investors in commodities face a political backlash that could disrupt markets. A U.S. Senate hearing June 24 showed lawmakers are seriously considering intervening to stop or slow speculation. The topic was "Ending Excessive Speculation in Commodity Markets: Legislative Options."

Michael Masters, of Masters Capital Management, told senators that speculation is artificially raising commodity prices, and backed proposals to limit or block institutional investors from directly investing in the market. "In the last five years, institutional investors have adopted the mistaken belief that commodities futures are an investable asset class, similar to capital market investments," Masters said.

Among the institutional investors, of course, are the mutual funds that invest in commodities.

The Commodity Futures Trading Commission is studying whether index funds really are inflating market prices artificially. The government agency promises to report its conclusions to Congress by Sept. 15.

It's impossible to predict how much longer the commodities boom will continue. But for investors, this superheated investment class may be getting too hot to handle.

Steverman is a reporter for BusinessWeek's Investing channel.

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