How to Invest in Commodities—and Why You Should

For the first time since 2010, commodities are showing signs of life. So far this year, a diversified package of commodities is outpacing both the stock and bond markets. But if you hold some of these basic materials in your portfolio—or are tempted to get back in now—you'll want to be careful about how you ride the turnaround.

See Also: Watch Out for Overpriced Stocks

Beyond improving performance, there are two good reasons to hold some commodities—or, to be more precise, investments that track the price of commodities. Diversification is one. Research shows that commodities typically don't move in sync with stocks and bonds, and that's holding true now. Year to date, the Dow Jones-UBS Commodity index, which tracks 20 commodity markets, including corn, gold and oil, has gained 7.9%, whipping the return of Standard & Poor's 500-stock index by 5.3 percentage points and the Barclays U.S. Aggregate Bond index by 4.5 percentage points (all returns are through May 22).

Commodities can also act as a type of insurance policy against sudden spikes in the price of goods. Inflation in the U.S. has been tame lately, but severe weather and political events have helped push up prices of certain raw materials. For example, the Indonesian government's decision in January to halt nickel-ore exports propelled the price of the metal (which is used to make stainless steel) to a gain of more than 40% so far this year. And a drought in Brazil, the world's largest coffee producer, has helped lift the price of arabica coffee by more than 80% since November. Some commodities also serve as safe havens against geopolitical uncertainties. From the beginning of the year through mid March, when the Russia-Ukraine standoff reached a crescendo, gold climbed 13%.

But commodity prices are notoriously volatile, and other trends could serve to keep a limit on prices and maybe even drive them down. One development to watch is slowing growth in China, a major importer of raw materials. Gold in particular is known for having long boom and bust cycles, and as the U.S. economy improves, fewer investors may seek out the yellow metal as a safe haven. After rallying in the first ten weeks of 2014, gold, at $1,294 per ounce, has fallen 7% since mid-March. Paul Christopher, chief international strategist at Wells Fargo Advisors, believes the price could tumble to as low as $1,200 by the end of the year. "We've been advising clients to start unloading," he says.

All of which suggests the road ahead for commodities could be bumpy. Chris Philips, a senior analyst in the investment strategy group at Vanguard, says it's a good idea to keep 5% to 10% of your portfolio in commodities—but only if you're willing to hold on for the long term. That may be easier to do with a mutual fund or exchange-traded fund that invests across multiple commodities markets. If you bet on a single commodity, you stand a good chance of getting spooked and selling at the wrong time. Recently, Vanguard studied the gains investors earned in SPDR Gold Shares (GLD), the largest ETF that tracks the price of gold. Vanguard found that from November 2004 (when the fund launched) through February of this year, investors earned an average of 3.2 percentage points per year less than the fund's stated return, mostly because of poor timing decisions. (Investors tended to bail out after prices fell and buy in long after a rebound had started.)

Four Great Commodities Investments to Consider

Most commodities funds and ETFs own futures contracts (an agreement to buy or sell a commodity for a set price at a future date). Futures contracts are easier to own than the physical commodity, which must be stored somewhere (and perhaps fed as well). But because of quirks in futures trading, fund performance does not always match that of the underlying commodity. To get around that, some funds buy contracts with varying maturities (rather than just roll over contracts from month to month as they expire, which is what usually happens).