Thursday, March 15, 2012

A Win-Win For Commodities

As you may already know, the growth of the global economy is very important to the success of the companies in the commodities sector.  More often than not, the demand for commodities will increase as living standards increase. Due to this, many economists and analysts believe that the majority of the worldwide growth in demand for commodities will come from developing countries.

Over the last several years there has been a dramatic market shift in developing countries.  China, for example, has shifted to a market system that uses more of the mechanisms of a market economy. This shift has had a significant impact on the commodities sector.  From oil to the most precious commodity of all, water, the increase in demand on the world’s commodity supplies by China has been increasing at an alarming rate.

According to the International Monetary Fund (IMF), global GDP growth is projected to be 4.00% in 2012 and 4.47% in 2013, being led by emerging economies where economic growth is projected to be 6.08% in 2012 and 6.48% in 2013.  The global commodities sector is made up of several different markets including agriculture, metals and mining, clean water supplies, forest and paper products and energy. These commodities are the essential building blocks of every economy in the world.

The USDA reports that global agricultural trade from 2011-2020 is projected to increase due to global economic growth.  This is based on the assumption that the growth rate will rebound to a 3.4% average growth rate for 2011-2020.  Import demands from developing countries are expected to continue to rise because population growth rates in emerging countries remain above those in the rest of the world.

The win-win for commodities could lie in the actions of our own Federal Reserve.  The Fed, over the last three years, has aggressively lowered the federal funds target rate in an attempt to boost the economy.  By doing so, they have also depressed the dollar.  A depressed dollar may encourage investors to continue to shift assets into commodities such as gold, which is historically known for holding value during times of rising inflation (a possible end result to the Feds actions).  I personally believe that economies around the world are improving.  Whether that has to do with our Feds policies or it is just a natural process I do not know, but I do know when economic activity accelerates, whether at home or abroad, the global demand for natural resources increases. The resulting increase in the underlying commodity prices historically generates higher profits for companies in the energy sector and translates into higher returns for investors these securities.

There are many ways to position a portion of your portfolio in commodities.  In my three personal tactical allocation models I like to separate my gold & precious metals investments from my pure broad-based commodities investments.  I try to maintain a weighting between 3.4% and 8.4% in gold & precious metals and a weighting between 3.3% and 8.3% in a broad-basket commodities investment.  Here are some specific product ideas for these two asset classes:

Gold & Precious Metals

SPDR Gold Shares (GLD) – If you are looking for a pure play on the price of gold this would be the choice for you.  This ETF is meant to track the performance of the price of gold.

Tocqueville Gold Fund (TGLDX) – I personally own this mutual fund.  I prefer to take a more managed approach to not only investing in gold but all precious metals.  I also like the fact that mining companies, such as Newmont Mining (NME) are owned in a fund like this.  I believe the earnings power of these companies gives a managed fund more power over the long-term versus index like returns that the GLD may provide.  However, there are single years where this can hurt performance, as it did in 2011.

I also believe the Gabelli Gold Fund AAA (GOLDX) is an excellent managed mutual fund choice.

Broad-Basket Commodities

The PowerShares DB Commodity Index ETF (DBC) is a “best bet” choice for many of you.  When you are talking about the vast array of commodities, which span from agriculture to oil to water to forest based products to precious metals, I often feel it is too vast for a manager of a mutual fund to navigate as efficiently as an index.

I personally take a more sophisticated approach with my commodity allocation.  Whenever possible I like to deploy strategies that offer disparity.  I feel it provides me with a better opportunity to take advantage of that disparity and reduced correlation.  For example, I divide my broad-basket commodity allocation evenly between a very conservative approach to owning commodities with a very aggressive approach to owning commodities.  The conservative mutual fund I like to use is the PIMCO Commodity Real Return Strategy D (PCRDX).  This mutual can often be found holding as much as 50% of the fund in cash and short-term treasury securities.  I counter-balance this approach with the very volatile Direxion Monthly Commodity Bull 2X fund (DXCLX).  This fund seeks to provide 2 times the return of the Morgan Stanley Commodity Related Index.  It does this with the use of leverage which also opens it up to almost 4 times the downside of the index.  Because I stick to a strict quarterly rebalancing schedule I am able to take advantage of the wild prices swings this fund has experienced.  For example, I rebalanced and bought more of the fund at the end of 2011, and the fund is up 14.54% so far in the first quarter of 2012.  If the quarter were ending today then another round of rebalancing would have me reducing my allocation in the Direxion fund, and thus I was able to take advantage of the funds quarterly outperformance.

Both precious metals and broad-basket commodities should have a place in your portfolio.  As with any investment you do not want to go overboard and own too much.  Gold has provided a tremendous hedge against currency risk and if you believe the world economy is improving then you will see pressure increase on the world’s commodity supplies.

Thank you and good luck everyone!

Jon R. Orcutt, founder of Allocation For Life, is an asset allocation strategist and author of “Master the Markets with Mutual Funds: A Common Sense Guide To Investing Success”