Hard Assets: Not the Easiest Investment Play

Though a host of fairly new exchange-traded products based on commodities are available, the only ETFs backed by physical commodities are in precious metals

By David Bogoslaw

It's easy enough to shrug off the growing demand among investors for commodities and other natural resources. After all, the economic recovery is sure to boost consumption of oil and other fuels, as well as larger quantities of base metals, steel, and timber as industrial production rebounds. Then there's the longer-term argument that growing populations and the reach for a better standard of living in emerging economies ensure increased demand for agricultural products and the flow of natural resources into the building of roads, bridges, and electricity grids for decades to come.

Astute investment advisers have long recommended some exposure to commodities for their clients in order to diversify their portfolios from the performance of stocks and bonds. Now there's an additional case to be made for commodities and hard assets: protection. The idea that commodities provide a hedge against rising inflation isn't new, but it's being augmented by mounting concerns about the risk of disorderly devaluations of the U.S. dollar and other currencies and runaway inflation some years out. The worries about the greenback and inflation stem from concerns about the consequences of central banks printing excessive amounts of money to pay for huge government stimulus programs.

Hence, the 9.8% jump in gold prices since the beginning of September. The SPDR Gold Shares ETF (GLD) currently holds nearly $40 billion worth of gold bullion sitting in London bank vaults. That makes it the sixth-largest holder of gold in the world, "right on par with what China or Switzerland holds," according to Paul Justice, an ETF strategist at Morningstar (MORN).

Widespread Investor Interest

"There's much more interest by institutions, endowments—every investor cohort—for inflation protection, for [emerging-market] plays," says Derek van Eck, chief investment officer at Van Eck Global and co-manager of the Van Eck Global Hard Assets Fund (GHAAX). "A lot of that is being driven by the policy stances taken globally by central bankers."

It turns out, however, that getting exposure to hard assets with low correlation to other asset classes isn't as easy as it sounds. Although a host of fairly new exchange-traded products based on commodities are available, the only ETFs backed by physical commodities are in precious metals.

The interest in physical metals comes down to practicality of storage, says Justice at Morningstar. "For other commodity classes, it doesn't make a lot of sense to use physical commodities. Natural gas would evaporate" and corn and wheat require silos and have the added risk of spoilage, he says.

Commodity futures are the instrument of choice for most retail investors, appealing for the lack of storage costs and their relative liquidity. Since you don't have to pay the full price of a commodity unless you end up taking delivery once a contract expires, you have more money available on which to earn interest, even if it's been set aside as collateral for the futures transaction, says Justice.

Closer scrutiny by the Commodity Futures Trading Commission (CFTC) and the threat of more stringent position limits to discourage speculation make ETFs backed by futures contracts less attractive than they once were. Regulators should be less concerned about commodity speculation by ETFs than by individual investors since "an ETF is a pool of investors [and] it's hard to say a mass of people are all speculating in the same manner," says Justice.

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