Don't miss out on the commodities boom

Oil, gas and gold are star performers outshining shares and bonds, says David Prosser

Forget shares and bonds. The smart money has been in commodities over the past year. While a modest recovery on the stock market is continuing, with the FTSE 100 Index of leading shares up about 14 per cent on 12 months ago, the oil price is now 43 per cent higher than it was at this time last year.

Forget shares and bonds. The smart money has been in commodities over the past year. While a modest recovery on the stock market is continuing, with the FTSE 100 Index of leading shares up about 14 per cent on 12 months ago, the oil price is now 43 per cent higher than it was at this time last year.

There is no immediate sign of a slowdown. On Tuesday, the US government said the price of oil was likely to hit all-time highs this year of about $50 a barrel. Other commodities are doing well, too: thanks to surging copper and aluminium prices, the Reuters CRB Commodity Index hit a 21-year high last week.

Most investors have missed out on these gains. Although the influential Barclays Capital Equity Gilt Study, published last month, recommended that any balanced portfolio should be 5 per cent invested in commodities, the majority of private investors have no exposure to the market.

The commodities sector is diverse. It spans fuels such as oil and gas, precious and base metals, and a range of soft commodities, including everything from sugar to orange juice. In practice, all but the most specialist investors avoid the latter, preferring investments in energy and metal.

There are two reasons to be interested in commodities. The first is the straightforward investment story, says Marc Gordon, managing director of Close Fund Management, which is currently raising money for a new commodities fund.

"The demand from the world's developing economies for oil and gas is surging," Gordon says. "And demand in Asia for industrial metals is also huge, as countries such as India and China build new infrastructure."

At the same time, Gordon points out that supply of commodities is not easy to increase overnight. It isn't possible suddenly to start producing more oil, or to increase gold mining. Reserves are limited and, in the case of some commodities, running out.

Mark Mathias, managing director of Dawnay Day Quantum, which is currently offering a commodities-based individual savings account (Isa) investment, says the global economy has changed. "The last big boom was driven by increased demand for services in the developed world," he says. "Now the boom is for physical goods: Asia is desperate for commodities."

The second reason to consider commodities is that spreading investments around different asset classes hedges your bets.

It is partly possible to do this through existing investments. Ben Yearsley, an investment analyst at independent financial adviser Hargreaves Lansdown, says that while few investors have bought commodity funds, let alone raw commodities, they may have exposure to the sector through other means.

"If you hold a UK equity fund, you probably have 20 per cent of your money in oil and mining stocks because companies such as BP, Shell and Rio Tinto account for such a large chunk of the UK stock market," he says.

Even so, Yearsley thinks investing more directly in commodities is a good way to diversify, albeit on a cautious basis. "With anything specialist, 5 to 10 per cent of your whole portfolio should be your maximum investment," he says.

As explained below opposite, investors have access to several funds that buy into companies involved in different commodities sectors. It is also now possible to invest in funds that trade commodities directly. The latter are a better way to diversify, argues Mathias. He says investors seeking to reduce risk need assets that have a negative correlation with each other; that is, their prices tend to move in opposite directions at any given time.

"There's a fundamental difference between holding shares in companies with exposure to commodity prices and the physical commodities themselves," says Mathias. "Physical commodities have a negative correlation with both shares and bonds, whereas shares in mining companies, say, by definition don't."

Mathias argues that by using shares to buy exposure to commodities, investors lose one of the most attractive features of the asset class: that it is a good hedge against disappointing returns on the stock market.

However, there are significant risks in commodity investments. Jamie Allsopp, manager of New Star Hidden Value fund, holds 10 per cent of his assets in commodities, but he prefers to invest in commodities-related companies. "Prices are buoyant but the investments can be very volatile," he warns.

There is also a danger that investors could be getting into commodities at the top of the market. Evy Hambro, who manages several mining and commodity funds for Merrill Lynch, says: "It's true that prices can't go on rising forever, but on the other hand, companies in this sector are now in much better shape."

Another risk is that commodities currently represent a gamble on the economic health of developing nations, particularly China. While there is every reason to be positive over the longer term about the prospects for the developing world, short-term ups and downs can produce disastrous results for investors.

Against that, some commodities are a safer bet than others. Gold, for instance, is traditionally the ultimate safe haven for investors worried about investment uncertainty. It will benefit from unforeseen shocks to the global economy - the effects of major terrorism, for example.

One person definitely sold on the commodities market is Jim Rogers, a professional US investor with a reputation almost as glamorous as that of Warren Buffett. Rogers has just published his latest book, How Anyone Can Invest Profitably In The World's Best Market, in which he argues: "The next bull market is here. It's not in stocks. It's not in bonds. It's in commodities."

Rogers argues that commodities have a reputation for high risk because so many investors have bought exposure through the complicated and dangerous derivatives market. In theory, he says, they should actually be less risky than shares.

After all, while a company can go bust, leaving shareholders with nothing, physical assets such as gold and oil will always have some value.

TWO WAYS INTO THE SECTOR

Professional investors win and lose fortunes by investing in commodities through futures contracts.

For most people, avoiding derivatives and investing through a collective fund makes much more sense. Their money is pooled with cash from other fundholders; and fund managers generally avoid the futures markets.

The first option is to invest into a unit or investment trust that gives exposure to commodities by buying shares in the companies that produce them.

Ben Yearsley, of Hargreaves Lansdown, tips two particular funds: First State Global Resources and JP Morgan Fleming Natural Resources. Both are broadly based.

Alternatively, two fund managers give direct exposure to commodities. Close Fund Management's Enhanced Commodities will invest equally in oil, gold and industrial sectors. It has a five-year life, with the fund guaranteeing your starting capital back at the end, plus 200 per cent of the return delivered by these three sectors.

Dawnay Day Quantum's Commodities Accelerator also operates over five years, with a 100 per cent capital guarantee, plus 200 per cent of performance. It casts its net wider, with exposure to five metals, plus crude oil, natural gas and heating oil.

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