By Debbie Carlson

Figuring out the right allocation for commodities in a portfolio can be tricky. Too big an allocation leaves average investors subject to missed opportunities in other assets, since commodity investments don't pay dividends or have earnings. Too little or no exposure means not taking advantage of the diversification that commodities offer, and missing out when these assets rally during supply shocks.

Picking individual commodities is also tough since they don't move in lockstep, as what causes cocoa or copper prices to rally often doesn't matter to corn or crude oil.

The best strategy for investors, experts say: having a small, long-term position in a broad-based commodities exchange-traded fund.

Stake size

Investors need only a small commodity position to enhance a traditional portfolio. Using a portfolio of 60% stocks and 40% fixed income as a baseline, portfolio strategists historically have suggested carving out between 2% and 10% from the stock allocation for commodities, depending on macroeconomic conditions.

In the current macro environment -- with inflation still over 2%, persistent geopolitical uncertainty, and climate change causing more extreme-weather events, according to scientists -- some commodities experts say a 5% broad-based allocation may be appropriate for individual investors.

Conversely, market pros say, investors should be mindful that commodities may underperform during deflationary cycles or periods when geopolitical risks abate or commodities supplies spike.

A 5% stake in commodities in a $1 million portfolio is only $50,000, says John Person, founder of investment-advisory service Persons Planet. "That's not going to tear away that much, but it would certainly offer some exposure to commodity movements that could do well in the next three to five years," he says, pointing specifically to geopolitical worries and extreme weather globally affecting crop production.

Considering inflation

Kathy Kriskey, commodity strategist at Invesco, says commodities are an efficient hedge in inflationary environments. Inflation is falling, with the September consumer-price index at 2.4%. It remains above the Federal Reserve's 2% target, however, and above a level Kriskey consider key for commodities.

Her research shows since 1998, when the CPI is greater than 2%, commodities broadly had positive returns 74% of the time. When the CPI was less than 2%, commodities had negative returns 84% of the time.

Kriskey says these trends underscore why having broad exposure, versus cherry-picking certain commodities, matters when it comes to owning natural resources as an inflation-fighter. In the most recent bout of inflation, she says energy and agriculture markets outperformed gold, which traditionally has been seen as the go-to inflation hedge. Gold plays a better role as a safe-haven hedge, she says.

Broad commodity-index-based ETFs that include exposure to the three major commodity sectors -- energy, metals and agriculture -- can be a way to incorporate commodities into a portfolio, versus directly buying futures or physical products, says Sterling Smith, an independent commodities research analyst.

"If you want to be diversified in commodities, and you don't want to sit and study, say weather patterns over Iowa, or be constantly wired in the markets, something like [a broad-based commodity ETF] will give you a macro exposure to commodities," he says.

When to buy and sell

Many investors think about commodities only when they make news, such as when cocoa prices rallied to over $11,000 a ton because of poor weather in top-producing countries, or when several commodities gained following Russia's 2022 Ukrainian invasion. Chasing headlines can be one of the worst times to start buying commodities since by the time a move makes news, much of the rally has occurred and prices could be turning, commodity experts say.

Trying to buy a specific commodity before the rally occurs is hard, even for professional managers, says Robert Minter, director of investment strategy at asset-management company Abrdn. Commodity markets are dynamic and changes in supply will move them, including weather, politics and other factors that are difficult to forecast.

Market pros recommend dollar-cost averaging, which is buying a set amount at specific intervals until the investor reaches his or her target allocation, or watching for price dips.

Minter says investors researching broad commodity-index-based ETFs should study the underlying index's construction so they get the exposure they want. Comparing two popular indexes as an example, he notes that nearly 60% of the S&P GSCI Commodity Index is composed of energy markets, while energy only makes up about 29% of the Bloomberg Commodity Index. The big difference in weighting will affect the return of those indexes.

He suggests investors dig into the index's sector holdings as well. Some commodity indexes may exclude markets that often have heightened volatility, such as natural gas. Not having exposure to natural gas means investors are missing out on changes in electricity-markets pricing during the summer or home-heating demand in the winter, Minter adds.

Having a commodities allocation isn't a set-it-and-forget it investment. The asset's volatility means allocations can easily grow or shrink beyond the 5% benchmark. Unlike stocks where some investors let their winners ride to compound gains, market pros say rebalancing is necessary.

"If you had a 5% allocation, and it's grown to 7%, then you want to trim the trees a little bit. Because when things change, and they will, you can walk away with a smile and not a frown," Smith says.

Debbie Carlson is a writer in Chicago. She can be reached at reports@wsj.com.

(END) Dow Jones Newswires

October 29, 2024 10:00 ET (14:00 GMT)

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