Are commodities necessary for a diversified portfolio?

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Conventional wisdom has it that advisors should steer 5% to 10% of clients’ investment portfolios into commodities to ensure proper diversification.

But many experts aren’t so sure.

“The idea you should always have x percent of your investments in commodities doesn’t play out,” says Ethan Anderson, a senior manager and advisor at Rehmann Financial in Grand Rapids, Michigan. “They can give you a buffer when stocks fall, but so can bonds, and commodities can perform worse than equities.”

It isn’t even clear that commodities provide diversification at this point, says Chris Litchfield, a retired hedge fund manager who is a private investor in Greenwich, Connecticut.

“Most assets are highly correlated now,” he says.

Advisors should focus on stocks and bonds to create a diversified portfolio for clients, Litchfield says.

“No one understands how commodities act in a portfolio,” he says. “You can’t say they are a diversifier.”

One problem is that unlike stocks, commodities don’t tend to rise over time, because technology improvements push their prices down. On an inflation-adjusted basis, The Economist’s commodity price index is essentially unchanged since 1871.

Another issue is that commodities don’t generate income like bonds and dividend stocks do.

“In certain periods where stocks look overvalued, we want to diversify” into commodities, Anderson says.

Now, for example, some of Rehmann’s clients are in gold miner stocks.

“Do I want direct exposure to a commodity price or to companies which operate in that area?” Anderson asks.

Investing in companies offers the ability to benefit from a company’s operating efficiency, even when the commodity price falls, he says.

Many fund managers invest in commodities through futures. But experts are wary of this strategy, because rolling over expiring futures contracts can be tricky and can cause losses for a fund.

A diversified stock portfolio will likely provide a significant exposure to commodities without the risk of investing in them directly, experts agree.

“I’m not saying that’s a better way to get exposure to commodities,” Litchfield says. “I just don’t think you have to allocate a separate pool of money to commodities to get adequate diversification.”

As an investor himself, if he was going to dive into commodities, Litchfield said that he would want an advisor with demonstrated expertise in the area.

“If my money manager was a [commodity trading advisor] and a [chartered financial analyst], then I might listen,” Litchfield says.

This story is part of a 30-30 series on navigating the growing world of choices for client portfolios.

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