How to Handle Volatile Commodities: Advice From LPL, S&P, Goldman

Volatility has investors battening down the hatches, seeking safe havens

As commodities prices reel around on a sea of volatility this month, investors are hanging on for the ride and trying to figure out how to curb their losses.

According to strategists and portfolio managers from Goldman Sachs, ETF Securities, Standard & Poor’s, LPL Financial and WFS Funds, investors can move their money into everything from  equities to exchange traded funds to mutual funds to options. The key, of course, is finding the right niche within those markets.

Gold’s story has been a volatile one since last week when it dropped, then rallied early this week, then dropped again later in the week. As of Thursday, Comex gold futures for June delivery fell $4.70, or 0.3%, to $1,497 an ounce following a 1% loss on Wednesday.

Silver, meanwhile, also declined Thursday after showing signs of recovery earlier in the week following a 30% downward plunge last week. On Thursday, Comex silver for July delivery fell $1.64, or 4.7%, to $33.92 an ounce. Silver had tumbled 7.7% in Wednesday’s session.

Why Commodities Have Plummeted

Commodities’ suddenly sharp volatility is the result of weak reports on U.S. unemployment and weekly jobless claims, and underscored by Federal Reserve Chairman Ben Bernanke’s insistent view that rising prices are out of line with what he considers to be low underlying inflation.

“The Wednesday before last week’s commodities drop, Bernanke was saying he was worried about mid-term inflation, not short-term. He said commodities were overextended, and wow, two days after Bernanke spoke, the bubble burst,” said Randy Warren, chief investment officer of WFS Funds for Warren Financial Service, Exton, Pa., which runs two institutional products for pensions, endowments, foundations, trusts and family offices.

Further, says Goldman Sachs Asset Management’s Chairman Jim O’Neill, the global economy is likely to encounter more “mini periods of volatility,” where

rising commodity prices, food and energy in particular, choke off some economic activity as consumers and business adjust to higher costs.

“In countries where overall inflation rises more because of these rising prices and central banks tighten monetary policy, subsequent tightening financial conditions will slow down growth and probably lessen their contribution to the demand for the commodities in the first place,” O’Neill writes in “Can Equities Rally Without Commodities?,” a viewpoint published on May 7.

“It appears as though we might be going through such a period right now," O'Neill continues. "Suddenly, economic data in many economies has disappointed, and while there could be a number of explanations, it seems quite feasible that the degree of increase in energy and food prices might be a guilty culprit.”

O’Neill concludes that if equities are to develop another leg to the rally that has been taking place since 2009, it will probably have to be led by something other than commodities. And more commodities weakness in the near term wouldn’t be that surprising either, he adds.

What Does Commodities Volatility Mean for Investors?

If gold tracks the classic bubble pattern, and it has so far, instead of plunging, it may double in value this year, according to Jeff Kleintop (left), chief market strategist for LPL Financial. However, he does not believe that gold – or commodities in general—is in a bubble and most likely will not continue to track the classic pattern. But he does see potential for further modest gains for precious metals and other commodities in 2011, to be accompanied by volatility.

“Gold’s rally is now just entering its tenth year, historically the best year for gains,” Kleintop writes in a market comment published Monday. “It is worth noting

that gold’s March 1980 peak at $850 is about $2,400 in today’s dollars when adjusted for U.S. inflation, well above the current price and near where gold would be headed if it tracked this classic pattern.”

Currently, gold prices have tracked the classic bubble pattern but have yet to enter the parabolic stage where the bursting of the bubble and the ensuing sharp losses begin to become a risk, which is after 10 years and a 1,000% gain, Kleintop says, pointing to 1990s bubbles in technology, oil and housing . “The investment bubbles of the past experienced far more inflating than what gold prices have experienced so far.”

Silver’s volatility shouldn’t put investors off the precious metals market altogether, said Will Rhind (left), managing director of ETF Securities, which sponsors some of the world’s largest physically-backed exchange traded funds.

Last week the ETFS Physical Silver Shares ETF (SIVR) fell 19.5%, while the ETFS Physical Precious Metals Basket ETF (GLTR), which comprises gold, silver, platinum and palladium, experienced an 11% drop. This difference in performance underscores the benefits of diversifying exposure “and not putting all your eggs in one basket,” Rhind noted in an email on Thursday.

“Even in a turbulent market, precious metals should be part of any investor’s portfolio diversification strategy, as they exhibit a low correlation to the equities market,” Rhind said. “Silver is a perfect example; while silver has been extremely volatile as of late, other precious metals prices have held relatively firm through the sell-off. In this type of environment, investors might consider investing in a precious metals basket, to diversify their exposure away from any single metal while still benefiting from precious metals exposure.”

Mutual Funds Also Offer Protection from Volatility

Standard & Poor’s mutual fund analyst Todd Rosenbluth says mutual funds may give investors the most evenly diversified exposure to Energy and Materials.

“If you wanted to invest only in the Energy sector, there are ETFs that are specific to Energy or Materials. The benefit of going with a mutual fund is you can get active management and exposure to both sectors. ETFs tend to be pure play or tied to an index. For some investors they’re too diversified, and for some investors they‘re too narrow,” Rosenbluth said.

A mutual fund screening performed on S&P’s MarketScope Advisor screening tool picks the following two natural resources funds, both rated five stars by S&P, with exposure to both the Energy and the Materials sectors:

Franklin Natural Resources Fund (FRNRX)
Fidelity Select Natural Resources Portfolio (FNARX)

Both funds are relatively low-risk, open-end funds available to individual investors. S&P ranks funds for past performance as well as the quality of the stocks in the portfolio and fund characteristics such as manager tenure and expenses.

Four-star-rated funds picks include:

RS Global Natural Resources Fund (RSNRX)
ING Global Natural Resources Fund (LEXMX)
BlackRock Natural Resources Trust (MDGRX)

Any way they play it, investors need to go one step further in order to hedge their bets in this volatile commodities market, said WFS Funds’ Randy Warren.

His WFS Big Dividend Strategy hedge fund, which invests in dividend-paying equities and options on the VIX, is open only to investors with a minimum investment of $750,000. But, he said, any investor can reduce volatility by investigating the VIX and options that avoid the roll cost of futures.

“For RIAs, that means being careful and manipulating your allocation,” Warren said. “If you think it’s just a pullback, you change your allocation, and if you think it’s going to get worse, you sell your commodities and put your money into something less volatile. Stubborn buy-and-hold investors get crushed in commodities.”

Read more about the volatile commodities markets at AdvisorOne.com

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