CHICAGO Commodities are among the most skittish investments. Not only do they react to global economic forces, they can seesaw with supply and demand, China's voracious appetite for raw materials and the weather.
Since commodities are tangible things that are mined or grown, they are hard to hold and often bought through futures contracts, which have their own peculiarities. Yet what is undeniable about commodities is that they are usually a good tracker of broad economic growth, inflation among producer prices and they run inversely to the dollar's decline. You should have a piece of them in your portfolio, but you have to be careful about how you hold them.
Here's how strange commodities are: Even though there was growth nearly everywhere except for Europe last year, commodities, as measured by the Dow Jones/UBS commodities index, declined 1 percent. That compares to a resounding 16 percent gain for the S&P 500 index of large U.S. stocks with dividends reinvested.
Commodities prices have been following muted expectations for the Chinese economy in recent years, which is now the world's largest consumer of raw materials.
Despite predictions last year that the Chinese export-driven economy would cool down due to slack demand in the euro zone and the U.S., according to HSBC, China's 8-percent growth rate may not slow down this year. The IMF reports that China is consuming some 40 percent of base metals, 23 percent of agricultural products and 20 percent of non-renewable energy resources.
Renewed growth in China -- 8.2 percent according to the 2013 IMF estimate last week -- will translate into heavier demand for ores, oil, coal and agricultural goods. The rebound may have already begun. Factory sector growth in China hit a two-year high this month, says HSBC.
Eric Weigel, director of research for the Leuthold Group in Minneapolis, says you have to be careful with how you play the "China effect." Buying baskets of commodities through managed index funds can skew results because of the funds' weightings. The Dow Jones/UBS index, for example, has twice as much invested in agricultural commodities than the rival S&P/Goldman Sachs Commodities Index, which has more than 60 percent of its holdings in energy.
It's hard to execute a commodities strategy using baskets, says Weigel. "From 2003 through 2007, that strategy did well, then fell apart." This was the nasty little secret of commodities, which were supposed to move in the opposite direction of stocks, providing some diversification.
Indeed, when worldwide demand for raw materials plummeted after the 2008 meltdown, commodities followed stocks, which dropped 37 percent. The S&P/GSCI got punched even more -- falling 46 percent that year. This high correlation blindsided many investors like myself, who were looking at historical numbers that suggested commodities moved in the opposite direction of stocks.
What's the best way to avoid falling into lockstep with stocks while using commodities as an inflation or a dollar hedge? Investing in a popular fund such as the PowerShares DB Commodity Index Tracking ETF has not worked recently. Although it holds more than half of its portfolio in petroleum products, it has returned 4 percent over the past three years through 2012. The fund was hurt by its large exposure to energy, as wholesale prices in that sector fell.
An alternative such as the iShares GSCI Commodity-Indexed Trust is similar, investing nearly 70 percent of its portfolio in energy futures, about 20 percent in agriculture and livestock and 10 percent in industrial and precious metals. It has gained 1.22 percent in the last year.
To boost your returns, a more focused approach might be a better way to play specific trends, such as the increased use of metals and petroleum products in Asia.
The Energy Select Sector SPDR focuses on major petroleum producers, pipelines and service companies, so you avoid the exposure to the other commodities. It returned almost 10 percent over the last three years and could more closely track growing demand for oil and its byproducts in emerging markets.
Another approach is to invest in a broader basket of stocks that concentrates on metals, chemicals and minerals needed in emerging economies. With that road map, a fund like the Vanguard Materials ETF could be a suitable choice. The fund holds big mining companies like Freeport McMoRan Copper and Gold, major chemical producers like Dow and agricultural companies like Monsanto. The fund gained almost 10 percent over the last three years and more than 17 percent last year.
However you craft your commodities strategy, take the long view. Commodities are among the most volatile asset classes. It is probably less risky to buy and hold companies that benefit from global growth and pay dividends than investing in funds that have futures-based strategies.
Also keep in mind that this asset class only performs well if there is growing global demand for commodities. Recessions or slowdowns will bruise returns. Advanced economies are only expected to grow 1.4 percent this year, the IMF predicts. Raw materials prices are also incredibly volatile, so keep this section of your portfolio under 10 percent of total holdings.
(The author is a Reuters columnist and the opinions expressed are his own)
(Follow us @ReutersMoney or here Editing by Lauren Young and Phil Berlowitz)