One Hot Commodity
The Pimco Commodity Real Return Strategy fund is racking up big gains and attracting hordes of investors. So should you be putting pork in your portfolio?
(MONEY Magazine) – Never mind nanotech or biotech or Web-search IPOs. These days big money is being made on hogs, heifers and heating fuel. The prices of many basic commodities are sky-high, and that's been a boon for the two-year-old Pimco Commodity Real Return Strategy fund (800-426-0107). Over the past 12 months, the fund has returned 29.5%, besting the S&P 500-stock index by nearly 18 percentage points. Numbers like that command attention—and cash. Commodity Real Return has already swelled to $5 billion in assets, surprising even the folks at Pimco. "The inflows have been eye-popping," says manager John Brynjolfsson.
Pimco is the biggest of a tiny group of open-end commodity funds, and (for better or for worse) they have opened up a new world for individual investors. Buying commodity futures directly is a complex game best left to diehard traders. Until recently, the simplest way for most of us to bet on, say, rising oil prices was to buy shares in a company that drills for it and sells it, such as ChevronTexaco (CVX). But oil stocks and oil prices don't move in lockstep.
The Pimco fund, on the other hand, is acutely sensitive to price moves in such assets. It doesn't actually own the commodities themselves. "We aren't looking to own a warehouse of corn or a side of beef," says Brynjolfsson. Instead, the manager buys derivatives whose value is linked to the Dow Jones-AIG commodity index, which tracks 20 different commodities, from oil and natural gas to gold to food. It takes a relatively small amount of cash to buy the derivatives, but those bets have to be backed up by other assets in case prices go the wrong way. Pimco keeps that collateral invested mostly in inflation-protected bonds, or TIPS. The return on the bond portfolio can add—or, potentially, subtract—a few percentage points to the fund's performance.
Hang on. Derivatives? Collateral? Do you really want to dabble in weird stuff like this? Some of the enthusiasm for Commodity Real Return can no doubt be explained by investors' desire to exploit oil prices that had topped $50 a barrel by late September. But the Dow Jones-AIG index—and therefore the Pimco fund—caps its energy weighting at 33%. By contrast, Pimco's main rival, the Oppenheimer Real Asset fund, has more than 70% of its assets in energy.
The real reason to buy this fund is diversification. "Commodities are a source of investment return that is completely uncorrelated to both stocks and bonds," says Chris Cordaro, a financial planner with Regent Atlantic Capital. In other words, when paper assets zig, commodities zag. In 1997, for instance, when the S&P 500 soared 33%, the Dow Jones-AIG commodity index lost 8%; in 2000, when the S&P fell 9%, the Dow Jones-AIG rose 24%. When you own assets that rise and fall on different cycles—even when some of those investments are risky by themselves—you can smooth out your portfolio's overall returns.
Right now commodities also look like a hedge against the very real possibility of inflation, which is traditionally lousy for both stock and bond returns. Real estate investment trusts and some international bonds have also done well in inflationary times, but commodities let you benefit directly from the rising demand associated with higher consumer prices.
What to watch out for
Commodities have had almost everything go in their favor recently. Outside the U.S., global economic growth has been robust. Developing markets like China, with their fast-growing middle classes, are hungry for more of just about everything. Meanwhile, terror threats and war in Iraq have everyone nervous that oil is about to become seriously scarce.
The trouble is, the commodities markets haven't failed to notice any of this, and they've already pushed prices up to reflect these hopes and fears. At some point, notes Morningstar analyst Karen Papalois, the supply of commodities usually catches up with demand. When that happens, commodity prices can fall fast. And since the Pimco fund just follows the index—Brynjolfsson doesn't change the portfolio to reflect his own guesses—it is bound to fall nearly as hard. (Those bonds might soften the fund's losses a bit, but only a bit.)
A fund like T. Rowe Price New Era, which invests in stocks of commodity-driven businesses, might hold up better when prices drop. The ChevronTexacos of the world, if they're well managed, can profit even if oil goes back to $30 a barrel. "Investors have to bear in mind that for [the Pimco fund] to do well, commodity prices have to not just stay high, but keep rising," says Papalois.
How much could the fund lose? Here is a rough idea: In 1998 the Dow Jones-AIG index dropped more than 30%.
"If people are going into this fund thinking they'll get rich, that's a mistake," says Coral Gables, Fla. financial planner Harold Evensky. Rather than putting lots of money into a commodities fund right now, Evensky suggests dollar-cost averaging—buying a little bit at a time so you get in at both high and low prices—and limiting commodities to no more than 10% of your portfolio.