The big story of the year so far has been the astounding developments taking place in the countries of the Middle East. It is fair to say that a larger percentage of humans can now point to the location of Tunisia on a map than would have been the case three months ago. And we watched with riveted eyes as popular demonstrations brought down the thirty year reign of Hosni Mubarak in Egypt.

Amidst these heady developments –with a mix of promise and peril for the citizens of these nations – are some concerns for the global economy. Foremost among these, perhaps, is that fears of oil supply disruptions will spill over into widespread commodities price inflation, which in turn could threaten the nascent economic growth we have been witnessing in the past few months. If inflation is going to be a factor to deal with in 2011 then history tells us that real assets – commodities like oil, agricultural products and base & precious metals – could help to hedge against weakness in other risk asset valuations. In reviewing their portfolio management strategies, investors should be aware of the different ways to add commodities exposure to a diversified portfolio.

Over long periods of time commodities exhibit similar levels of volatility to equities. The trick is that these two asset classes tend to perform in different ways for the same given period of time. In the language of investments we refer to this as low correlation – a desirable property for portfolios because it hedges the risk of something going really sour for any one exposure. Inflation can be a very souring influence on equities. Rising prices put pressure on businesses by increasing the costs of the materials they need to produce. They can either eat the higher costs and see their profits fall – which Wall Street never likes – or try to pass the cost increases onto consumers. But if consumers are feeling the pinch themselves they will likely respond to higher prices by buying less – in turn decreasing sellers’ sales and profits – and thus putting downward pressure on share prices.

Over time one would expect this kind of scenario to come back and hit commodities. Businesses facing lower sales will probably decrease production, demanding fewer commodity inputs and thus causing the prices of those inputs to fall. Logical enough. But that can take time to play out. And that is exactly why equities and commodities tend to do well at different times. Commodities prices will tend to be high when share prices are getting battered by poor sales or low profit margins, and by the time reduced demand has caused commodities prices to fall, businesses have probably stabilized and started to pick up again.

There are different ways to obtain commodities exposure through simple registered mutual funds or exchange traded funds. Funds may offer direct exposure to the underlying assets – like crude oil, copper or wheat – via managed  commodities futures. An example of a fund that takes this approach is Pimco Commodity Real Return (PCRRX). On the other hand, it is possible to obtain exposure via proxy by buying into shares of the companies that benefit from higher commodities prices – diversified energy, mining, agribusiness and equipment producers. An example of this would be Ivy Energy IEYAX. In this case you are actually buying equities, not commodities, but you would expect this sector to outperform in a period of high inflation because they get their revenues from the products that are costs to downstream businesses.

Exchange traded funds are another way to invest in commodities. PowerShares offers an ETF giving exposure to oil commodities futures (DBO) and another for agricultural products (DBA), while iShares operates an ETF for gold futures (IAU).

Bear in mind that commodities can be extremely volatile and trends can reverse on a dime. In the middle of 2008 crude oil prices seemed to be headed into the stratosphere, then plummeted in the fall when the economy went into a nosedive. And it is true that in the wake of the crisis commodities and equities have not been as lowly correlated as their historical norms have been. High inflation may not come to pass, the Middle Eastern oil supply may not be noticeably disrupted, and droughts may not ravage corn and wheat harvests this year the way they did last summer. But there is certainly a plausible case to make for the usefulness of commodities as a portfolio addition in the current climate.

TAGS: commodities, portfolio management