ALBERT HERTER

‘A CASE FOR COMMODITIES,’ by Fidelity Viewpoints at fidelity.com. A simple primer to inform yourself.

In Uncategorized on October 13, 2009 at 17:26

Around this time last year, Americans were fretting over $4-a-gallon gasoline. Flash forward one year and gasoline is averaging around $2.50 a gallon according to the Energy Information Administration. Crude oil prices—the raw material in gasoline—have dropped from a high of about $145 a barrel in July 2008 to around $70 according to the New York Mercantile Exchange.

Such price swings illustrate the extremely volatile nature of oil prices and other commodities. Despite such volatility, long-term, risk-tolerant investors may want some exposure to commodity-related investments because they may provide diversification benefits, protection against both inflation and the loss of global purchasing power, and the potential for capital appreciation. Commodity-related investments include commodities, the stocks of commodity-producing companies, and the mutual funds that invest in them. Before we analyze the current picture, we’ll cover what commodities are, what drives their prices, and their investment risks.

What they are

Commodities are typically raw materials derived from the earth that people consume directly (food and energy), or use to create products that people buy, use, or consume on a regular basis. This includes natural resources (oil, natural gas), industrial metals (copper, aluminum), precious metals (gold, silver), and agricultural products (wheat, corn, soybeans, and livestock). Commodities are the foundation of most consumers’ needs as opposed to services or wants.

What influences commodity prices?

The overall strength of the global economy and supply-and-demand levels are the most important drivers of commodity prices. These factors have led to multi-year bull and bear market cycles for commodities. For example, during the great bull market for stocks from 1982 to 2000, ample supplies of many raw materials, such as oil, kept a lid on the price of many commodities and economic growth was the driver from the service-based developed economies in Europe, the U.S., and Japan.

Over the past nine years, however, commodities, and commodity stocks, as measured by the S&P Goldman Sachs Commodities Index and the MSCI All Country World Commodity Producers Sector Capped Index respectively, have outperformed the S&P 500® Index (.SPX) due in part to surging needs-based demand from fast-growing economies in China, Brazil, India, and other developing nations.1

As credit markets worldwide froze up during the financial crisis the past year, many economies across the world seized up and contracted. This led to a dramatic collapse in commodity prices, along with stock prices for many commodity-producing companies, until the credit, financial and economic systems began to normalize in the spring. Despite this pullback, Joe Wickwire, manager of the Fidelity Global Commodity Stock Fund (FFGCX), believes the long-term outlook for commodities remains strong.

“I believe commodities are a good long-term global story, especially from a portfolio diversification standpoint. While economic growth in China, India, and Brazil has slowed of late, the industrialization of these and other developing economies has not come to a complete halt—and probably will not—so demand, albeit somewhat more muted, hasn’t been entirely choked off,” Wickwire says. “Further supporting commodities is that they have relative degrees of strategic importance attached to them. In many growing areas of the world where economies are not resource self-sufficient, governments can’t afford the risk of not having enough food, energy, and infrastructure for their populations and will thus seek to ensure sufficient supplies of each,” Wickwire explains. “The strongest economic growth in the world going forward is likely to be in developing economies, and these economies are disproportionately needs- or commodities-dependent at this stage of their economic growth. This should provide a very supportive environment over time.”

Just as people in the U.S. and other developed nations demand new roads, schools, and access to healthy food, people in developing nations around the world want to eat better, drive cars, and live in more comfortable homes. With a finite supply of many economic natural resources, the world will likely see expanding competition for commodities.

As the global economy stabilizes and begins to grow again, demand for commodities may expand. Already, massive domestic and foreign stimulus plans are triggering growth in infrastructure-related projects around the world, boosting global demand. At the same time, some commodities may remain in short supply.

“There are finite economic amounts of many natural resources, and the recent low commodity price environment forced many commodity industries to slow their production and cut spending on exploration and development,” says Wickwire. “Once demand really revs up, supply could be constrained, thus putting upward pressure on commodity prices.”

Because they are usually priced in U.S. dollars, commodity prices can be influenced by currencies as well as economic and credit conditions. Additionally, the global fiscal and monetary stimulus plans around the world could allow commodity prices to rise higher as many are aimed at projects and initiatives that are needs/commodity based.

Imperfect correlation to other investments

History has shown that the performance of commodities and commodity producers are not perfectly correlated to stocks, bonds, or currencies. Correlation measures the performance of two investments and the degree to which they move in the same—or opposite—direction. For example, during the 10-year period ending June 30, 2009, the S&P Goldman Sachs Commodities Index had a correlation of just 0.21 versus the Russell 1000 Index (.RUT). Performance of commodity producers had a higher, but still imperfect, correlation with that of broad domestic and foreign stock indices. As shown in the graphic below, commodity stock performance showed a similarly low correlation to that of fixed income investments.

Keep in mind, however, that correlations can change. Recently, the correlation between commodities and U.S. large cap stocks (Russell 1000 Index) was substantially higher than that seen over the last full ten years; it was 0.49 for the three year period ending June 30, 2009.2  Despite this recent rise in correlation with large-cap U.S. stocks and with equities in general, allocating a small portion of an already well-diversified portfolio to commodities or commodity stocks may offer the potential to reduce risk and add returns over a long time horizon.

A degree of protection against inflation

Additionally, because commodities are typically priced in U.S. dollars and they are the raw input to many of our expenditures, such as food, fuel, cars, and housing, they may also offer some protection from the impact of significant inflation on the purchasing power of a portfolio.

During past highly inflationary periods, commodities and commodity stocks have performed well relative to other assets. For example, during the 1970s, when inflation rose sharply, a diversified basket of commodities outpaced inflation while large cap U.S. stocks did not. The performance of two sectors containing the vast majority of commodity-producing companies provided an even greater cushion against the impact of inflation. While a commodity stock focused index did not exist in the 1970s, most commodity-producing companies can be classified within the energy and materials sectors.3  Over the period shown in the chart below, the returns of these two sectors outpaced inflation, and were also greater than those of commodities themselves. Energy stock performance was undoubtedly also affected by the Oil Crisis of the 1970s, which helped drive crude prices as high over $80 per barrel during that time.

What are the risks?

The commodities industry can be significantly affected by commodity prices, world events, import controls, worldwide competition, government regulations, and economic conditions. Apart from the risks associated with general commodity investing, there are risks to investing in the common stocks of commodity-producing companies. You should be willing to accept the risks that come with exposure to foreign and emerging markets, including political, economic, and currency volatility.

How to invest in commodities

Sophisticated and risk tolerant investors might be interested in trading commodity futures contracts or investing in the individual stocks of commodity-producing companies, but they’re likely too complex and volatile for most investors. A practical solution may be to invest in commodity-focused mutual funds and ETFs that either track the performance of commodities indices or invest in the stocks of commodity-producing companies.

Some investors may already have commodity investments in their portfolios. While not exclusively focused on commodities, some asset allocation funds also maintain a strategic allocation to commodities and commodity-linked investments. Some international and diversified equity funds with high weightings to the energy and materials sectors may also have considerable commodity exposure.

It’s also important to remember that commodities and commodity stocks can be extremely volatile. One way to help mitigate volatility is to consider investing in commodity-related investments using dollar-cost averaging to build a position over time. With this strategy you invest a set amount of money on a regular basis. This structured investment plan might help you put the volatility in the asset class to work for you, buying more shares when prices are low and fewer shares when prices are high. Keep in mind, however, dollar-cost averaging won’t guarantee you investment gains in a declining market or ensure against a loss.

Due to the potential for extreme volatility, an allocation to the commodities asset class should be a minority component of a well-diversified portfolio that is primarily composed of stocks and bonds.

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