Most Average Joes don't belong in commodities

You've probably never thought, "My portfolio needs more pork," or, "Let's add some sugar to these stocks." And there's a reason for that. It's what farmers call "stupid." In most cases, the only ones getting rich from commodity funds are the people who sell them.

You can, however, make a modest case for adding a diversified commodity fund to your portfolio. It's a thin case, though, and it's only if you expect a return to '70s-style inflation.

Let's start with the obvious: Unless you have great insights into the sugar industry or the steel industry, you have no business investing in the insanely focused commodity investments now available. For example, iPath sells an exchange traded note that tracks the Dow Jones-UBS Tin index. It's up 45% this year. Quick, what's the price of tin? If you don't know, you probably shouldn't buy the iPath UBS Tin ETN. (For what it's worth, tin sold for $6.90 a pound on the London Metals Exchange on Thursday.)

But here's a better question: What on earth is the iPath Dow Jones-UBS Tin Total Return ETN?

An ETN is a credit obligation of the issuer — in other words, it's a promise to pay a certain amount at a certain time. Its ultimate value depends on the issuer's ability to pay the note at maturity. This particular ETN is issued by Barclays Bank, which is rated AA- by Standard & Poor's. Repayment isn't guaranteed by any federal agency. Students of recent history may recall that owning long-term unsecured debt can sometimes be problematic.

Commodity ETNs are generally linked to an index — in this case, the Dow Jones-UBS Tin subindex, which tracks the value of tin futures. You can buy and sell ETNs on the stock exchanges, and their market value typically follows the price of the underlying index, minus the issuer's annual fee.

You'll notice that the top-performing commodity investments the past 12 months (see chart) are all specialized ETNs. If the ETN part of the investment doesn't worry you, the fact that they are so specialized probably should, because forecasting commodity prices is tough. Just 17 people say they called the recent rise in sugar prices correctly, and you shouldn't believe 15 of them.

You can, however, make a case for owning a small stake in a broad-based commodity fund. Commodity prices tend to have a poor correlation with stocks and bonds, which means they don't necessarily move in lockstep with each other. That's a good thing: If stocks go down, commodities could go up, cushioning the financial pain of a broad-based stock sell-off.

The Commodity Research Bureau index of commodity prices has just a 10.5% correlation with the S&P 500-stock index since 1959, which is exceptionally low. A 1983 study by Harvard professor John Lintner showed a very low correlation between managed commodity futures pools and stocks, and suggested that adding modest amounts of commodities to a stock portfolio can increase performance and decrease risk.

So, does it help to add a diversified commodities fund to your portfolio? Typically, only in periods of rip-snorting inflation. In the 1970s, commodity prices soared. The Reuters/Jefferies CRB index jumped 170% from Dec. 31, 1969, through Dec. 31, 1979. The S&P 500 gained 3.8% the same period.

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