Historically, commodities such as wheat can cushion portfolio losses when other asset classes dive (and dampen the gains when these classes soar).Getty Images/iStockphoto
An asset class is a group of securities that exhibit similar characteristics, behave similarly in the marketplace, and are subject to the same laws and regulations. www.investopedia.com
To many investors, constructing a diversified portfolio is a matter of choosing an asset allocation from stocks, bonds and cash. Yet, the asset class tent is much bigger than these core portfolio building blocks. Commodities, gold, real estate and real return bonds are frequently touted as investments that add something to a portfolio beyond what stocks, bonds and cash have to offer. Do any of these lesser-used classes add enough value to merit a place in your portfolio?
Commodities
Barrels of crude oil, pounds of copper, bushels of wheat, pounds of cotton – these are some examples of commodities, i.e. marketable goods typically of agricultural or mining origin. Historically, commodities have had a low, or even negative, correlation with stocks, bonds, cash and real estate. They cushion portfolio losses when other asset classes dive (and dampen the gains when these classes soar). These characteristics mean that adding commodities to your portfolio can produce better risk-adjusted returns.
Investing directly in commodities by buying futures contracts requires a level of knowledge, time and skill that is beyond the average investor. A small holding of a broad commodity exchange-traded fund (ETF) is a practical way to gain the benefits that this asset class offers. Buying a U.S.-listed ETF such as the iShares S&P GSCI Commodity-Indexed Trust (GSG-N) will keep your holding in the currency of commodity trading, the U.S. dollar. For investors who want a fund hedged to the Canadian dollar, the iShares Broad Commodity Index Fund (CAD-Hedged), (CBR-T) trades on the TSX.
Gold
Gold is a unique commodity. It has found favour with investors as insurance against bad times. When the world is going off the rails, fearful investors traditionally sell stocks and buy gold bullion because, well, because people have traditionally done so. This lemming-like stampede increases the demand for gold and higher prices follow. A good example of this behaviour is the gold price action following the 2008 financial crisis. According to the U.S. Bureau of Labour Statistics, "From September 2010 to September 2011, gold prices jumped 50.6 per cent, due to speculation surrounding an uneven recovery and volatility in the U.S. financial markets."
Gold is also touted as a hedge against the ravages of inflation.
Does gold really perform as advertised? The authors of a recent Financial Analysts Journal article on the role of gold in asset allocation think not:
– "…gold should not be counted on as a safe haven in times of extreme stress, such as war."
– For horizons up to 20 years, the timeframe of most investors, gold may be a poor inflation hedge.
Over the long term, gold has been a relatively poor performer. The researchers at Investorsfriend.com have calculated that from 1926 through mid-2013, gold provided a compounded average annual real return of 1.8 per cent whereas stocks returned 6.8 per cent and corporate bonds delivered 2.9 per cent. Gold prices are subject to the machinations of the central banks of this world. As Warren Buffett has declared, "If you own one ounce of gold for an eternity, you will still own one ounce at its end." It is not difficult to conclude that your portfolio can glitter without gold.
Real return bonds
Real return bonds (RRBs) are long-term bonds issued by the Government of Canada. Like regular bonds, they pay interest semi-annually. What makes them a distinct asset class is that this payment is adjusted for inflation based on changes to the Consumer Price Index. At maturity, the principal is repaid in inflation-adjusted dollars. Due to this unique design, RRBs preserve the purchasing power of the invested principal, a property that the core asset classes largely lack. This inflation protection ability earns RRBs a place in most portfolios, especially retirement savings accounts. While RRBs can be purchased directly, a mutual fund such as the PH&N Inflation-Linked Bond Fund or an ETF such as BMO Real Return Bond Index ETF (ZRR-T) will deliver broad diversification with just one purchase.
Real estate
Real estate provides portfolio diversification due to its low correlation with bonds, and to a lesser extent, with stocks. Real estate also acts as a hedge against inflation.
Since almost 70 per cent of Canadian households own their homes, many of us already have enough of our net worth tied up in this asset class. Investors who need some real estate in their portfolios could buy a dedicated fund such as the BMO Equal Weight REITs Index ETF. Including a smattering of international real estate in the mix will boost the portfolio diversification even further. Either iShares Global Real Estate Index Fund (CGR-T) or the U.S.-listed SPDR Dow Jones Global Real Estate ETF (RWO-N) would provide broad international real estate exposure the average investor could not achieve on her own.
Beyond stocks, bonds and cash, lie asset classes such as real return bonds, real estate and commodities that are worth investigating for the value they can add to your portfolio.
(Asset class correlation data from Morningstar Office Correlation Matrix for the 14 Asset Classes was consulted for this article.)
Ms. Bebee is Canada's independent voice on personal finance and author of No Hype –The Straight Goods on Investing Your Money, a popular book of investing basics for Canadians from a financial industry outsider viewpoint. Through her writing, speaking and teaching, Gail shows people how to take control of their money and achieve their financial goals. Her column appears monthly on the Financial Road Map site. Her website is www.gailbebee.com