Hedging With Commodities Requires the Right Mix

(By Kirsty Wigglesworth -- Associated Press)
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By Jane Bryant Quinn
Sunday, July 19, 2009

If you want to hold commodities in your investment portfolio, what's the best way?

The simplest commodities investments follow various indexes. You'll find a wide choice of exchange-traded funds (ETFs), exchange-traded notes (ETNs) and traditional mutual funds. There's no standard index that all the funds follow. Some tilt toward energy, others toward gold or grains. Yet others treat all commodities equally.

The fund you choose isn't only a bet on the commodities; it's also a bet on a particular asset mix.

Commodities have just come off a five-year boom. From 2003 to mid-2008, energy prices soared 320 percent in dollar terms, metals and minerals gained 296 percent, and foodstuffs rose 138 percent, according to the World Bank. They crashed last year, along with everything else, rebounded from March through May this year and then eased off again.

The World Bank says the boom is over because of slower global population and income growth. But commodities still attract dollar bears -- often such assets rise in price when the dollar declines and vice versa. They also appeal to inflation pessimists, even though commodities aren't a reliable hedge against rising prices.

Inflation Concern

Michael Crook, an investment strategist for Barclays Wealth in New York, says inflation is unlikely to surge anytime soon.

He says that there's plenty of spare capacity in the system, that unemployment will probably stay high and that central banks are discussing when to pull back the money they have thrown at the global credit crisis.

But the huge budget deficits are still creating expectations of inflation, with "hyperinflation" on some lips. That concern alone might be enough to drive up commodity prices, Crook says, for a while, at least. Price pressure will also arise from the growth of developing countries, where goods production still trumps services and the population is increasing its consumption of protein.

Diversification is the best argument for holding some small percentage of your money in commodities -- say, 5 percent. Their prices generally move up when stocks move down and vice versa. Over time, commodities are no more volatile than equities and yield a slightly lower return, Crook says.

ETNs vs. ETFs

If you buy, do you want an ETF or an ETN?

Commodity ETFs invest directly in commodity futures. They are usually structured as interests in a limited partnership, so at tax time in the United States, they generate a Schedule K-1. Any annual income and profit are taxed.

Precious-metals ETFs are trusts that hold the metal itself. When you sell, you are taxed at a maximum rate of 28 percent on long-term gains.

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