Smarter Commodity Plays

Sure, they're volatile, but there are ways to minimize the risks. Here are a few options for hedging your bets on the commodities market

by David Bogoslaw

With oil prices hovering around $100 and precious metals prices hitting all-time highs, investor interest in commodities has been reignited. Worries that the U.S. economy is sinking into a recession, however, have economists trying to decide whether strength in commodities is a boom with long-term potential or another bubble destined to burst. A recession would likely reduce consumer demand for energy, metals, and agricultural products—giving naysayers a reason to stay away from these volatile investments.

On the other hand, some pros believe commodities prices still have plenty of room to climb. Their strength is pushing inflation rates up, as measured by the latest spikes in the consumer price index, or CPI, and the producer price index, or PPI (BusinessWeek.com, 2/26/08). In turn, advisers recommend investing in commodities as a hedge against inflation.

S&P's Diversified Trends Indicator

However, the key premise for investing in commodities in recent years is that they add diversity to a portfolio because of their relatively low correlation to stocks and bonds. With major equity indexes down more than 10% from the highs reached just four months ago and Treasury yields under pressure from multiple Fed rate cuts, investors are more eager than ever to put their money into commodities.

Depending on your risk tolerance and return targets, financial advisers recommend allocating 3% to 10% of your portfolio to commodities. Most vehicles for individual investors are designed to bet only on higher prices. However, funds that track the Standard & Poor's Diversified Trends Indicator (DTI) use a market-timing strategy that either go long in or short particular areas, such as agriculture or metals, within the commodities world. These funds essentially let you place bets on when certain commodity prices will rise and fall. (Standard & Poor's, like BusinessWeek, is owned by The McGraw-Hill Companies (MHP).)

Half of the DTI is allocated to commodities futures and the other half to financial products such as U.S. Treasury bonds and notes and foreign currencies. The index can take a short position on any commodity except those in the energy sector.

While some financial advisers eschew short bets on commodity futures because of their high volatility, risk in the DTI is controlled through diversification and the weights of each of the components compared with the index as a whole, explains Victor Sperandeo, who created the DTI in 1999. Another factor limiting risk is that, unlike most commodity futures contracts, the DTI doesn't use leverage, so even if a bet goes bad, the loss would be limited to the size of the individual commodity's weight in the index. "When you use a noncorrelated asset like the DTI, you actually do not increase your risk. You literally lower your risk," Sperandeo says.

Since 2001, when S&P began to publish the DTI on its Web site, the index has delivered a 6% annualized compounded rate of return. Over the past seven months, as the volatility in stocks and bonds has soared, the DTI has risen 12% to 13%.

The Rydex Fund

Currently, the Rydex Managed Futures Strategy Fund (RYMFX) is the only way for individuals to invest in the S&P DTI. This mutual fund invests in structured notes whose prices are tied to the DTI, rather than actual commodities futures. Rydex contracts with major investment banks such as Goldman Sachs (GS) and JPMorgan Chase (JPM) to create these structured notes.