Diversify your risk with commodities

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Commodities have often featured in periodic booms and busts, but they have also offered attractive returns over sustained periods and provided a good way for investors to diversify risk.

That is the conclusion of a research paper by US investment firm Vanguard, which has looked at the returns on 30 commodities since 1959, including popular areas such as gold and crude oil as well as more esoteric products such as feeder cattle and rough rice. Vanguard has no axe to grind: it does not offer a commodity product among its range of low-cost tracker funds.

The problem, says Peter Robertson, its head of business development and strategy, is cost: "If the [running] costs are 2 to 3%, what you gain from diversification you lose in charges."

But plenty of other firms offer commodity products. Indeed, the huge interest in the asset class is a key reason for the rapid growth in exchange traded funds (ETFs), which offer the easiest and cheapest way to gain exposure to hard and soft commodities.

The choice is bewildering: FE Trustnet lists 514 exchange traded commodities ranging from Gold Bullion Securities (GBS) - Britain's first commodity ETF, which gives exposure to gold - to esoteric offerings such as leveraged agriculture or nuclear energy.

Looking for the lowdown on gold and other safe-haven investments? Take a look at our focus on precious metals.

The diversity of commodity product structures can add to the confusion. Exchange traded funds, which are compliant with European Ucits regulations, cannot invest directly in physical commodities so must use derivatives to get exposure to the underlying commodity. ETCs can invest directly in the commodity. However, because of the difficulty of storing commodities such as pork bellies and timber, physical backing tends to be restricted to precious metals, while futures or other derivatives are used to replicate the performance of other commodities, or baskets of them.

"The growth in commodity ETFs has been phenomenal over the past few years," says Tim Cockerill, head of collectives at Rowan Dartington. "Investors are able to access investments that a few years ago they could not have considered looking at - especially in the area of soft commodities such as wheat, sugar or cotton.

"There are pluses to this, as it offers an opportunity to diversify a portfolio. But, on the negative side, is investing in commodities such a good idea?"

Gold remains one of the most popular commodities. With many experts predicting economic travail on both sides of the Atlantic, the price of gold should rise and gold is likely to remain a favourite commodity. Products such as Gold Bullion Securities or iShares Physical Gold (SGLN) offer investors a far easier way to get exposure to the metal than buying bullion or Krugerrands, which used to be the only way to invest in gold.

Nick Brooks, head of research at ETF Securities, says physical products offer investors comfort that their funds are fully backed by real assets and are tightly linked with the price of the product. But he adds: "That is not practical for agricultural products, oil, natural gas and so on. The only way to invest in these is through the futures market. You can do that directly through a derivative or by using an exchange traded product that tracks futures returns."

For most investors, commodities should be a relatively small part of their portfolio. The best starting place will be through funds that offer exposure to a basket of products, perhaps through an all-commodities index, or several baskets such as industrial metals, precious metals and agricultural commodities.

ETF Securities, for example, has products that track the Dow Jones UBS Commodities index, as well as its sub-sectors, such as industrial metals, agriculture, energy and precious metals. Investors can use these to build a portfolio that will cover all the main assets.

Interest in agricultural commodities has grown rapidly but has been controversial. Some activists - and even governments - have complained that speculation in these products, and in food-related commodities in particular, is pushing prices up and causing genuine harm as food prices in less developed countries rise.

Cockerill thinks this is one reason to think carefully before investing in these areas. He says that, while long-term drivers should fuel rises in agricultural commodity prices, these prices depend on factors that investors cannot predict or control, such as the weather and the planting decisions of millions of farmers.

The only commodity on his firm's recommended list is a physical gold ETF.

However, Patrick Connolly, head of communications at financial advisers AWD Chase de Vere, warns that gold's rapid ascent means investors risk buying at the top of the market. He adds that a balanced portfolio of equities will already give most investors considerable exposure to commodities - about a third of the FTSE 100 (UKX) consists of oil and mining shares.

Those who want to tap into growing demand for foodstuffs, but without directly investing in them, could consider an ETF that tracks the shares of food producers and other agricultural companies, such as the ETFX S-Net ITG Global Agri Business Fund (AGRI), which tracks around 30 global agricultural companies. It was up 45% over the year to 1 July but it's been a rough ride since then, showing a loss of 22% in the six months to 1 October.

As well as avoiding single commodity funds, most private investors should steer clear of the more complicated leveraged or short ETFs, which are likely to be extremely volatile and have been attracting attention from regulators.

Brooks says investors must ensure that they have adequate information about a product and how their investment is protected. In particular, they should check what arrangements are in place to guard against the collapse of the bank providing the futures contracts or derivatives. "If you are not sure you have enough information on [a product], don't buy it," he says.

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