Financial Geekery

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.)

A couple years ago I wrote a cautionary post in the wake of the run-up on gold over the past decade. Since then, gold has…well, not gone really anywhere, and neither have commodities in general. So I figure now is a good time to talk about investing in commodities, when people aren’t jumping up and down about how they’re going through the roof (or the floor).

Don’t speculate on commodities. Well, I don’t recommend speculating on investments, ever, but it’s especially true for commodities. You think the stock market is a roller-coaster ride? Commodities will make you lose your lunch! Remember back in 2008-2009, when the S&P 500 got cut in half? GSG, an ETF that tracks the S&P Goldman Sachs Commodity Index, plummeted by two-thirds, and it’s hovering at around half of its 2008 high even today. Yes, the runup on gold since 2000 is drool-inducing, but so were internet stocks before 2000 and real estate before 2008. Don’t become yet another cautionary tale.

Don’t look to commodities to boost your returns. “OK, fine — I’m investing in commodities for the long term. They’ll make me rich!” No, they won’t. By definition, commodities are items that can be replaced. Any time any given commodity gets too expensive, corporations start figuring out how to do without it — witness the explosion in hybrid technology when oil prices were shooting up a few years ago, or the move to copper wiring by companies that traditionally use gold. No, over the long term commodities barely keep up with inflation — no surprise, since the price of commodities is pretty much the definition of inflation. (Gold has historically been no exception…which should make current holders of the shiny stuff very cautious when looking at charts like this.)

Don’t invest in commodities as your primary hedge against inflation. Afraid of inflation? Invest in Treasury Inflation-Protected Securities! While they have normal interest just like any other bond, their principal is adjusted for inflation, which makes TIPS a safe, low-volatility way to guard against inflation. (By design, their yield is exactly their inflation-adjusted return!) While commodities track inflation over the long term, they may go for years before reverting to the mean; in mathematical terms, they have a positive but lower correlation with inflation than TIPS.

Do invest in commodities to reduce your overall portfolio volatility. Commodities are very interesting in that they don’t often move in tandem with either stocks or bonds. This means that, with regular rebalancing, a canny investor can take advantage of commodities to smooth out their portfolio, selling commodities when they are high to buy stocks and/or bonds, and vice-versa, with the overall effect of reducing volatility. Now, note that I said “don’t often move in tandem”; in 2008, they crashed along with nearly everything else, so don’t look to commodities to work miracles. That’s the job of short-term treasuries!

So yes, commodities can be a useful part of your portfolio, if bought for the right reasons. Next stop — how (and how not) to invest in them!

Though the financial media buzz has faded somewhat in recent years, ETF’s (exchange-traded funds) exploded in popularity in the mid-2000′s as an alternative to index funds. What are they, and should you invest in them?

An exchange-traded fund is exactly what it says: a fund (mix of securities) that sells on a stock exchange. A regular mutual fund has its price re-computed at the end of the day by looking at the value of all of the securities that are in it; shares of an ETF, on the other hand, are actually bought and sold themselves. This seemingly small change can make all the difference in the world:

• ETF’s often (but not always) have lower expense ratios than their corresponding indexes. Why? Because a mutual fund firm has to deal with a lot of paperwork when mutual funds are bought and sold, because they are the ones that have to process it. Not so with an ETF; since they’re sold on a stock exchange, the brokers do all the work there. (The ETF has some work to do — I’ve sidestepped the whole issue of how the price is maintained — but it’s comparatively small peanuts.) This alone can be a good reason to invest in ETF’s, as expense ratios are just about the only way to differentiate between funds that follow the same index, but that advantage comes with several less-obvious disadvantages:
• ETF’s often (but not always) have commissions. Since you have to buy and sell ETF’s through a brokerage like Schwab or Fidelity, they’ll often charge you a commission to make the trade. If you’re putting a part of your paycheck into an IRA every month, this can quickly eat up any gains you may have gotten over an index fund (and then some!). However, many of the ETF’s most investors are interested in are offered commission-free by the broker; you just have to be careful what you buy. (Of course, mutual funds often have commissions, too.)
• ETF’s are very difficult to auto-invest. As of this writing, the only popular brokerage I know of that allows you to automatically invest in an ETF is ING’s Sharebuilder, which, while cheap at $4 per automatic investment, is not commission-free. The others only allow automatic investment for mutual funds. Of course, if your ETF has a commission, you probably won’t be automatically investing monthly anyway; likely, you’ll save up in a money market account every month, then invest in ETF’s once every three or four months, so you’re only charged the commission three or four times a year. Either way, it’s not as easy as mutual funds.
• ETF shares are generally more cumbersome to trade. With mutual funds, you just tell your mutual fund company how many dollars of your funds you want to buy, sell, or exchange (in the case of rebalancing), and the firm takes care of it all at the end of the day, no muss, no fuss. With ETF’s, if you’re rebalancing, you have to sell the shares from the too-high ETF, wait for everthing to clear, then buy the shares from the too-low ETF. And in the meantime, because you can only buy whole shares, you’ve got money piling up in your money market account, leftover from each trade. On the whole, annoying.
• ETF’s have a bid/ask spread. Because they’re traded on an exchange, there’s a small amount of “friction” involved in buying or selling an ETF, in the form of a bid/ask spread. The more you trade, the more the spread will eat into your returns. Mutual funds do not have this problem.

So, are all the disadvantages worth the lower expense? They can be; however, it’s worth it to sit down and plot out how much you would save in dollars per year if you moved from an index fund to an ETF, and make your decision based on that.

(One note: if you use Vanguard (and I highly recommend you do), there’s virtually no reason to use an ETF. Why? Because they recently lowered the minimum for purchasing Admiral Shares of many of their funds to $10,000, making them very accessible, and in just about every instance, the expense ratio for Admiral Shares is exactly that of the corresponding ETF!)

Got a preference? Tell us about it in the comments!