Commodities Are Finally Rebounding -- Here's How To Profit

StreetAuthority Network

Those who loaded up on gold, oil and other commodities a few years ago in anticipation of raging inflation related to quantitative easing are likely very disappointed.

As most investors probably know, commodities have trailed stocks pitifully in recent years. The Dow Jones-UBS Commodity Index (DJ-UBSCI), which tracks a group of 20 commodities, fell 6.5% a year for the past three years, while the S&P 500 gained 17.6% annually during the same period.

But one of the nice things about investing is just about everyone gets a chance to be right if they wait long enough... and commodities investors may finally be having their day. 

Indeed, commodities appear to be staging a comeback, with the DJ-UBSCI already up more than 7% this year, compared with a 5.6% gain for the S&P.

One probable factor in this resurgence: rising consumer prices. According to the latest inflation data (released by the Bureau of Labor Statistics on June 17), the Consumer Price Index (CPI) jumped 0.4% in May -- twice the 0.2% increase economists expected. What's more, May's 0.3% increase in the core CPI, which excludes food and energy, was the largest since August 2011.

With inflation apparently accelerating, investor demand for commodities will probably also continue to rise, since commodities are widely considered to be excellent hedges against inflation. They also tend to have weak correlations with stocks and bonds, meaning if the latter are dropping in price then commodities will probably be gaining value. 

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However, it's easy to get burned in commodities because of extreme short-term price swings, which end up spooking many investors into selling at large losses. That's why it's a good idea to make commodities a relatively small part (no more than about 10%) of your overall portfolio. It's also best to own a broad basket of them for maximum diversification and lower volatility.

The best broad-basket commodities investment I've seen is PowerShares DB Commodity Index (NYSE: DBC), an exchange-traded fund (ETF) that provides exposure to the world's most heavily traded commodities such as oil, gas, gold and other metals, and agricultural products like corn and wheat. 

The fund has been around since 2006, so it's well-established. It's also popular with investors, with invested assets of $5.6 billion and a reasonable 0.85% expense ratio.

Like any index fund, DBC has to mirror a benchmark -- in this case, the DBIQ Optimum Yield Diversified Commodity Index, which typically holds 14 different commodities futures (contracts to buy or sell assets at predetermined future dates and prices). DBC's holdings as of March 31:

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^DUBS Chart

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^DUBS data by YCharts

Of course, DBC never actually takes possession of the physical commodities underlying its futures positions, as this would be impractical. Rather, like its benchmark, the fund follows a so-called optimum yield strategy.

With this method, futures that are about to expire are sold and replaced with equivalent contracts set to expire at later dates in a process known as rolling. The goal of rolling is to get the highest possible roll yield -- the amount of return generated when swapping out one futures contract for another, based on the contract prices.

Over time, rolling futures with an eye toward optimum yield helps to minimize the negative effect of contango, a term for when expiring contracts are trading at lower prices than the ones that will be replacing them. In that case, the fund has to shell out more for the replacement than it got for the expiring contract. Conversely, the optimum yield strategy helps to maximize "backwardation," which occurs when expiring contracts are trading at higher prices than their replacements.

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While an optimum yield approach can significantly affect fund returns, the main factor in DBC's long-term performance is the value of the commodities underlying its futures holdings -- and as I said, commodities look set to go up.

DBC's current record reflects recent travails, though. During the past three years, the fund lost about 3% a year. Still, it soundly beat the DJ-UBS index, which declined more than 6% annually during the same period. DBC's trailing three-year record places it in the top 45% of its category.

Risks to Consider: Because it's a broad basket, DBC is certainly less risky than individual commodities futures. However, investors should still expect some pretty big price swings from the fund, which has been 23% more volatile than the S&P 500 during the past three years.

Action to Take --> Investors seeking to hedge against inflation with commodities should consider DBC because of its diversification, solid performance, greater safety and low cost.

The only unusual thing about the fund is that it's classified as a partnership for federal income tax purposes. This means investors must account for their proportional share of any income, capital gains or losses, or deductions passed through to them by the fund. This is typically done on Form K-1 at tax time.

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