Why commodities make sense now

Stocks and bonds. When most people think of investments, that's where they start. Lately, however, some investment professionals are suggesting that people take a look at commodities and commodity funds.

The reason is obvious to anyone who has filled up a gas tank: Prices have been surging - and not just for oil.

Increased demand combined with reduced supplies for commodities such as copper, nickel, iron, and natural gas have helped fuel big gains in commodity prices over the past four years. One index of 17 commodities reached a 24-year high last week and is closing in on the peak set in 1980.

Fortunately, there are ways for the individual investor to profit. Just as the price of commodities has soared, so have commodity funds and more broadly invested natural-resources funds. For the 12 months ended March 11, natural-resources funds posted an average return of 40.7 percent, beating all other domestic-fund categories for the period, according to Morningstar Inc. in Chicago. Meanwhile, the PIMCO Commodity Real Return Strategy Fund, for example, gained nearly 95 percent from its inception in June 2002, through Jan. 31 of this year.

Commodity and natural-resources funds' gains can be explained by simple economics: higher demand and lower supply. While many people were chasing returns by investing in the Internet, telecommunications, and technology in the 1990s, commodity producers steadily cut budgets and reduced capital spending over an eight-year period from 1997 to 2004, according to Morgan Stanley Capital International. As a result, when demand for commodities started to pick up in 2000 and 2001, inadequate supply led to higher prices and higher returns for commodity and natural-resources funds.

"We have a bull market in commodities because supply and demand has gotten out of whack," says Jim Rogers, investor and author of "Hot Commodities: How Anyone Can Invest Profitably in the World's Best Market." "There's been only one lead mine opened in the world in the last 25 years. There have been no great oil discoveries in over 35 years. Fields deplete. Mines deplete. After 25 years of no investment in production capacity, supplies are running low, demand is continuing to grow."

Even when higher prices begin to support new development, "it takes several years, five to seven years, to bring a new mine into production," says Louis Stanasolovich, a fee-only financial planner in Pittsburgh. "Prices only recently got high enough to justify starting to develop new mines."

But given the stellar returns of commodity and natural-resources funds over the past few years, is it too late for investors to cash in? "We view commodity funds probably as being in the fourth inning of a nine-inning game," Mr.

Stanasolovich says. "They have had a nice run-up so far. I think you'll get three out of the next four years being positive, which I don't think you'll get from the normal stock market."

Stanasolovich's baseball analogy is in line with historical patterns, analysts say. Over the past 130 years, commodities and stocks have tended to trade off outperformance in cycles that last an average of 18 years. 2004 was the fourth year of outperformance for commodities, says Curt Morrison, a stock analyst with Morningstar.

"Commodities do tend to outperform stocks from time to time," Dr. Morrison adds. "I think we're in one of those periods now. It started a few years ago, but I think it's going to last quite a bit longer."

Both Stanasolovich and Morrison believe most investors would be comfortable having about 10 percent of their portfolios in commodity funds, although the exact amount would depend on the investor's time horizon and comfort level.

"If you're going to need money in less than five years, then you probably don't want that money in stocks or commodities," Morrison says. "The volatility is such that if you need to pull your money out in five years, you may not have the same value any more. But I think 10 years is plenty."

It is impractical to take possession of physical commodities, and futures contracts are not appropriate for most investors, Morrison says, because they are rather complex and are often purchased using leverage, or borrowing, to purchase shares.

But these barriers can be overcome, he notes, by purchasing one of the open-end funds that invest in commodities: Oppenheimer Real Asset and Merrill Lynch Real Investment, and the PIMCO fund. This fund's "D" share class is no-load, although investors need to purchase shares through a discount broker or one of the mutual-fund networks, such as Fidelity or Charles Schwab. Then there is the Rogers International Raw Materials Fund, based on Rogers' International Commodity Index, which has increased 205 percent since August 1998.

Finally, Scudder Investments, a unit of Deutsche Asset Management, recently launched the Scudder Commodity Securities Fund.

As is often the case when any investment gets more attention, investors can expect to see more new funds focused on commodities.

"I think there's going to be more coming," Stanasolovich says. "A lot of these alternative funds will start to come out now that the stock market hasn't done so well. All we need is another down year in the stock market and I think you'll see a lot more of them come out."

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