There's nary an industry expert who would argue against the long-term merits of having commodities in a balanced portfolio. A diversified basket of metals, energy and agricultural products has shown to improve returns and reduce volatility, while acting as an effective hedge against inflation. And there are various ways for advisors to get their high-net-worth clients such exposure: through hedge funds, partnerships, stocks, mutual funds, ETFs and ETNs.

Despite a recent sell-off that sliced about one third off a key benchmark, and the whipsaw effect of September's high-profile failures and bail-outs in the financial sector, commodities have been performing well for quite some time. According to the Standard & Poor's/Goldman Sachs Commodity Index (S&P/GSCI), commodities gained 15.80% over the past year through September 15. Five-year annualized returns were up 13.41%. And ten-year returns appreciated 12.38%.

Commodities have trounced the S&P 500, which was down 17.94% over the past year, up 4.56% per annum over the last five years, and returned 3.08% annualized over the past decade.

For the record, the S&P/GSCI benchmark comprises energy, industrial metals and precious metals, and agricultural commodities. It's weighted by global production. This means a heavy tilt toward energy, which currently makes up more than three-quarters of the index.

The basic question for advisors looking to help their clients jump in for the first time: Should they consider doing so during the current slide or wait until prices stabilize? At the same time, for those whose exposure has grown fat on the run-up, should they consider taking some profits off the table or let their positions ride?

The Case for Commodities
Before the current rally began, a recent report by the City of London Investment Management Group (IMG) recalled that commodities were in a 20-year-long funk. This was most evident in the collapse of market capitalization. Between 1980 and 2000, the broad-market industry weighting of natural resources declined from 35% to just 5%, according to S&P.

Then came a perfect storm of events, starting in the mid-1990s, that's been driving the current rally. The end of the Cold War opened up tremendous growth across Eastern Europe. Chinese and Indian demand for raw goods began increasing exponentially, and these countries were joined by a number of Latin American economies. Developed market demand surged following the recession of the early 1990s and again after Sept. 11, 2001.

A five-year sampling of spot prices by S&P through the end of 2007 shows that copper rose nearly 34% a year. Crude oil jumped by more than 25% annually. Wheat was up more than 22% a year. More volatile natural gas prices, which collapsed nearly 44% in 2006, saw more limited annualized gains of just 9.3%.

The second argument for commodity exposure comes from a 2006 study by asset allocation specialist Ibbotson Associates. It revealed that exposure to this asset class reduced overall portfolio risk while boosting total returns by more than a full percentage point.

Thomas M. Idzorek, CFA, director of research at Ibbotson and the study's author, tracked commodity performance from 1970 through 2004. Despite their sluggish state during the 1980s and 1990s, commodities generated the highest returns of all investments while being negatively correlated to all major asset classes. He also found commodities were positively correlated to inflation, thus making them a good hedge against rising prices.

Moreover, Idzorek thinks there is little risk that commodities will dramatically underperform other asset classes on a risk-adjusted basis over any reasonably long period and suggests an optimal allocation range between 9% and 14%.

Near The Top?
While Idzorek makes his case statistically, a problem may come in applying his conclusions in the real world. Commodity prices are notorious trend animals. If an advisor moves his clients into this arena late into a rally and then suffers a significant drawdown, he may be tempted to get out before the sell-off bottoms and prices rally into the next uptrend.

Indeed, moving capital into commodities at this time could mean investing in a bubble where some prices have gotten well beyond their underlying fundamentals. Within a matter of a few days in the second half of July, the S&P/GSCI index sold off 10%. A similar rebalancing may be in store due to the events transpiring in the days after the bankruptcy of Lehman Brothers and the massive government loan to AIG when precious metals saw double-digit increases and agricultural commodities plummeted.

Before commodities began selling off in July, JP Morgan's Chief Market Strategist David Kelly thought there was inordinate risk in energy exposure (which, we remind you, currently represents more than three-quarters of the S&P/GSCI index). He said at that point, "Buying oil and many other popular commodities is more speculation than investing and not consistent with basic long-term principals of fundamental wealth management."

Kelly agrees prices have been driven by strong demand and insufficient supplies and exacerbated by geopolitical concerns. But he also sees the price being pushed forward by the increasing use of oil as a hedge against a weak U.S. dollar; by the huge flows into commodity funds; and by a surge in speculative trading of oil futures by disinterested players.

AIG Financial Products projected that $200 billion alone has been directed into commodity index funds worldwide over the last year through the end of June. However, Eric Kolts, commodity indexes product manager at S&P, thinks the market is large enough to handle that influx of capital without seriously moving prices.

With the doubling of oil prices over the last year, Kelly does see a bubble forming. But because the oil markets are an amalgam of unpredictable forces, he thinks shorting is also a dangerous prospect.

Edward L. Morse, who was Lehman Brothers' chief energy economist, is downright bearish about oil and regards the current market as "Dot-Com II." Before crude started sliding, he said oil inventories will start building up this fall. Production at deepwater wells will increase with the arrival of new extraction equipment. Refinery capacity will expand over the next five years, and will be capable of processing dirtier crudes. Just as important, he suspects that Chinese growth will slow after the Olympics. By year's end, Morse thinks oil will have collapsed below $100.

But then there are folks like those at Goldman Sachs who are predicting oil will hit $200.

Gaining (And Understanding) Exposure
High-net-worth investors can access two commodity-focused investment vehicles: hedge funds and partnerships. The most transparent type of hedge funds are commodity trading advisors (CTAs). Their investment positions and performance are reported monthly, collected by firms that follow the industry.

According to Sol Waksman, head of the data-tracking firm BarclayHedge, six commodity-focused CTAs with three-year track records (the longest meaningful period available) gained an average 28.59% a year through the end of May. They outpaced the S&P and DJ indices by more than 10% annually with volatility that's in between the two indices.

The most compelling feature of five of the six CTAs is that they can go short as well as long, giving investors potential protection if markets change direction. And in this kind of environment, that could be the most attractive skill set of all.
Vienna, Austria-based FTC Capital's Commodity Fund Alpha relies on the systematic (as opposed to discretionary) trading of liquid commodity futures contracts, currently targeting energy (45%), base and precious metals (25%), and grains and soft crops (25%). Having started up in April 2005, FTC's trailing three-year annualized returns through May were 23.4%.

According to Roy Ratliff, an independent registered rep based in Kentucky who focuses on private placements, qualified investors can gain direct ownership rights to oil, natural gas and metals through general and limited partnerships. Ranging in size from $500,000 to $300 million, and available to investors during limited offering periods, partnerships also typically offer attractive tax benefits, where an investment can be entirely deducted after just a few years.

However, Ratliff urges investors to consider partnerships only via an experienced broker or private banking service that is thoroughly familiar with the opportunities and risks of partnerships.

He recommends visiting theIPAonline.org, a Web site maintained on behalf of private placement issuers as a way to promote greater information about partnerships. But Ratliff says there is no industry clearinghouse or data tracking service that compares partnerships and their sponsors the way they compare funds. So due diligence is extremely important.

Ratliff urges investors to initially focus on key issues such as: 1) the level of sponsor participation; 2) the independent verification of geological findings; 3) a copy of the drilling and mining permit; 4) management's track record in all previous ventures; 5) the transparency and quality of investor relations; 6) the existence of a third-party due diligence report; and 7) audited financials.

More traditional and instant commodity exposure can be gained through industry-leading equities such as BHP-Billiton, the world's largest mining company, which is based in Australia and whose shares have almost tripled in U.S. dollar terms over the past five years through July 23. Suncor Energy, a leading Canadian extractor of oil from tar sands, has seen its shares rise more than fivefold. And shares in U.S.-headquartered conglomerate Archer Daniels Midland, a leading global agricultural commodity producer, have more than doubled.

However, since mid-April, ADM has plummeted more than 38%. And since their peaks in the third week in May, Suncor, Freeport-McMoRan and BHP are all now down more than 20%.

A more passive, diversified approach advisors can take is through ETFs and ETNs. The leading names in this area are Invesco's PowerShares, Barclays Global Investors' iShares, UBS' E-TRACS and Merrill Lynch's ELEMENTS. Some of these products track specific commodities, such as timber and forestry, biofuels and platinum. Others offer access to broad-based commodity indices, for which most advisors would likely opt.

But there is a big difference among the various diversified indices. As mentioned earlier, the S&P/GSCI index is production-weighted, with energy contracts representing nearly 78% of the fund. Industrial and precious metals represent 8.11%. Agriculture exposure is 14.16%.

The DJ/AIG Commodity Index tries to reflect the "economic significance" of each sector, and so it strives for diversity with a 33% limit on sector weightings. Energy, accordingly, tops out at one-third of the fund, while the agricultural and metals weighting is 2.5 and 4 times their respective positions in the S&P/GSCI. This balance constrains volatility, with annual deviation running less than 15 versus nearly 22 for the S&P index.

Such different content results in different kinds of performance. Because of oil's strong showing, one-year returns of the S&P/GSCI through June are up a whopping 76%. Three- and five-year annualized returns were 19.74% and 21.30%, respectively, while ten-year gains were 15.50%. The Dow Jones AIG Index gains were more modest. One-year returns were 41.56%. Three- and five-year gains were 18.84% and 18.60%, respectively. And ten-year returns were 13%.

Commodity funds can vary by more than just their underlying indices. Mihir Worah, portfolio manager of the PIMCO Commodity Real Return Strategy Fund, which tracks the DJ/AIG Index, has consistently outperformed his benchmark, doing so by 15.53% over the past year for reasons that go to the heart of how a commodity fund works.

Most of these funds don't buy stocks; they invest instead in the futures contracts of the actual commodities. This requires little up-front payment. But it does require managers to hold the bulk of their assets in collateral, typically short-term Treasurys, to meet margin calls in case contracts fall in value.

In seeking above-market returns, Worah maintains the same sector exposure in something like energy as the index, but then he alters his subsector bets (for example, he will invest more heavily in heating oil and go underweight in gasoline) where he thinks there's the most upside. At the same time, he manages his collateral holdings to exploit interest rate trends. Currently, he's invested in inflation-linked Treasurys with an average maturity of seven years via the Lehman Brothers TIPS Index. This meant that when the Fed cut rates last year, his collateral soared 15%.

Because it is actively managed, Worah believes his fund offers a more complete inflation hedge than most other indices. "Commodity exposure provides protection at the wholesale price level," he says, "while TIPS provide it on the retail CPI level."

The E-TRACS UBS Bloomberg CMCI Index ETN reveals further strategic variation. Not only does UBS believe it has conceived a more balanced commodity index than S&P's and Dow Jones', but the bank claims its investment in more diverse commodity contract lengths, ranging from three months to three years, produces better results. Pro forma analysis between December 1997 and April 2008 indeed showed this, along with less volatility of 12.2.

Looking for even more octane or reverse drive? Leveraged exposure can be found in exchange-traded securities such as Direxion's Commodity Bull 2x Fund. Inverse exposure can be gained from Deutsche Bank's DB Commodity Short and Double Short ETNs. Advisors can also short long ETFs to bet against the market.

However you decide to gain commodity exposure for your clients, make sure you understand what's under the hood. Even the most similar-looking investments can be quite different. And given the sharp U-turns commodity markets can make it essential to constantly monitor them.