What are commodity investments?

Commodities are physical assets such as precious or base metals, energy products, agricultural products, livestock and other raw materials. People typically invest in commodities by buying and selling shares of commodity-producing companies or by trading commodity futures or derivative contracts.

Low correlation helps diversification.

Many commodities are not highly correlated with stock and bond investments, meaning those commodity prices historically tend to move in different directions from these more traditional investments. Therefore, commodity investments can offer diversification benefits and help to insulate your overall portfolio from volatility in stocks and bonds.

What factors can influence commodity investment values?

Unlike many stocks and bonds, commodities do not provide a future cash flow stream. This makes it difficult to determine a standard present value. For many commodities, simple supply and demand can dictate day-to-day pricing. However, commodities with perceived strategic value, such as gold and oil, can be subject to psychological factors and geopolitical or macroeconomic concerns. For example:

• The price of oil rose dramatically in the years following the Sept. 11, 2001, terror attacks, coinciding with increased military activity in the Middle East and an uptick in demand due to unprecedented growth in China. Previous increases had coincided with the Yom Kippur War and Arab Oil Embargo in 1973 as well as Iranian events from 1978–1989 (e.g., the exiling of the Shah, the U.S. hostage crisis and the invasion of Iraq).
• After dipping briefly in 2009 during the global economic crisis, the price of gold soared in 2010 as uncertainty surrounded the beginning of the recovery. Gold’s most recent previous high had been at the end of the 1970s, a period of high U.S. consumer inflation. After dipping briefly in 2009 during the global economic crisis, the price of gold soared in 2010 as uncertainty surrounded the beginning of the recovery. Gold’s most recent previous high had been at the end of the 1970s, a period of high U.S. consumer inflation.
• Food, cotton and copper have all seen significant increases over the past year – a period when emerging economies like China saw growth accelerate again. The last period of appreciable, consistent growth for cotton prices came between 1973 and 1980.
• As the chart below shows, commodity investment prices in general can increase during periods of rising inflation.

How have commodity investments performed over time?

The chart above also shows that commodity performance has been inconsistent over the past four decades. We’ve already demonstrated how historical context can influence commodity prices. Some additional points worth noting:

• Commodity values fell sharply (along with many other asset classes) after peaking in June 2008 and have been on the rise – very much like equities – since February 2009.
• While equities have posted periods of negative returns lasting 10 years in the past, they have never had a 20-year period of negative returns; commodities did in the periods ending 1995, 1999 and 2008.

Under certain economic conditions, commodities can offer opportunities to manage risk through diversification. They can be used as at least a temporary hedge against inflation, which many investors and economists are expecting to see rise in 2011 and 2012. However, there are many factors to consider. You should consult your Baird Financial Advisor about your specific situation and goals, and discuss the potential role that commodities could play in your portfolio.