Commodities for the long run

CHICAGO (Reuters) - The combination of drought, rising food prices, population growth and climate change is a witch's brew for policymakers and big trouble for developing countries, but it's also a good reason to invest in commodity funds.

While it's always dangerous to project recent events into long-term forecasts, commodity prices are likely to increase over a long cycle, mostly due to rising population and meager productivity gains and possible shortfalls in food production.

Predictions like these have been wrong in the past - just look at the writings of Thomas Malthus or Paul Ehrlich - but it's undeniable that burgeoning populations in the developing world will put pressure on food prices, land resources and agricultural productivity.

Jeremy Grantham, a money manager with Grantham Mayo, took this up in his July newsletter, recommending a 30 percent allocation to resource-related investments for "any responsible investment group with a 10-year-horizon or longer." Grantham favors farms, forestry, fertilizers and "resource efficiency plays" that benefit from increasing agricultural productivity.

While I'm always a fan of diversification and long-term investing trends, unless you're a sophisticated trader, commodities should be pooled, buy-and-hold investments for most people. While they provide some protection from price inflation over time, they should not be confused with Treasury inflation-protected securities, or TIPS. If you want principal guarantees, these bonds are a more secure vehicle.

But there are options for the individual investor. The iPath DJ-UBS Grains Total Return Sub-Index exchange-traded note, for example, is designed to reflect the performance of a sub-index of grain futures contracts in corn, soybeans and wheat. It is up more than 15 percent year-to-date through June 29.

That's a good return compared with its peer index (down almost 3 percent), but investors should note that it comes with a myriad of risks - one of which is that its unsecured debt is backed by the credit of Barclays Bank, which was enmeshed in recent scandals and management changes involving manipulation of the LIBOR rate. Don't invest in the note unless you fully understand how the fund operates.

In contrast, a much broader-based fund that tracks petroleum products, metals and agricultural contracts is the PowerShares DB Commodity Index ETF). It's up 4.5 percent year-to-date through July 31. It's based on a Deutsche Bank commodity index linked to 14 of the most heavily traded and important commodities in the world that range from aluminum to wheat. About 10 percent of the fund's holdings are in corn and soybeans.

TAKING RISKS

Although commodities usually move in the opposite direction of stocks, they can sometimes move in lockstep with them. That was the case in 2008, when they followed stocks down in the market meltdown. On a macro scale, if there's a hint of an economic downturn, traders will sell off commodities. That's because the demand for things like metals and minerals will decline during a recession.

You should take a hard look at the myriad risks that commodities pose to your portfolio, so they should never dominate your holdings. The PIMCO Commodity RealReturn Strategy Fund, which I've held in my individual retirement fund for years, has an entire paragraph of risk factors in its annual report. They include derivatives, currencies, leveraging, short-sale, management, convertible securities and non-diversification, among many others.

Although I originally bought the PIMCO fund as a hedge against stock market declines and inflation, it lost nearly 44 percent in 2008, more than the S&P large-index loss of 37 percent. While the risks were spelled out in the prospectus, I had little idea it would perform that badly and follow stocks so closely in a global decline.

I continue to hold the fund and it's rebounded; up almost 40 percent in 2009, and up 23 percent in 2010, but down 8 percent last year. Still, I'm not happy with the past correlation with stocks in a major downturn, so I'm going to sell it.

Another risk factor to keep in mind is volatility. Commodities prices are notoriously skittish. Since they are not linked to earnings or dividends, they gyrate with market news.

Right now, the focus is on the long-term forecasts that the demand for food won't keep up with the supply. If you add global warming and increased extreme weather events into the mix, that's typically a formula for higher prices and a good reason to invest in commodity funds.

This is already happening. The U.S. farm belt has been hit with record heat and little rain, so grain prices hit record highs recently as nearly 1,600 counties were declared disaster areas. Food prices could climb as much as 3.5 percent this year and up to 4 percent in 2013 due to the drought, the U.S. Dept. of Agriculture estimates.

While it's hardly a satisfying feeling hedging against commodity price increases that will ultimately make food more expensive for those who can least afford it, I also monitor new farming methods that help to promote lower-cost, sustainable agriculture. Since I'm surrounded by farms, I never lose sight of the fact that food production is something all long-term investors should be concerned about.

(The author is a Reuters columnist and the opinions expressed are his own. For more from John Wasik see link.reuters.com/syk97s)

(Follow us @ReutersMoney or here. Editing by Beth Pinsker Gladstone and Dan Grebler)