Are Commodities Still Doing Their Job?

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When conducting experiments, scientists have to stay on guard for the phenomenon whereby simply looking at something changes what they're looking at. Investors have to follow a similar warning: If enough people plow into a new sector of the financial markets, they can collectively change the way that sector performs -- and not always for the better.

In a decade when the stock market has performed abominably, investors have searched for investments that can buck the flat-stock trend to provide positive returns. Several years ago, commodities gained popularity with their reputation for adding diversification and providing returns that weren't correlated with the stock market. But as commodities have become more of a mainstream investment, those benefits may have disappeared.

Saying goodbye to diversification
At last week's Morningstar ETF Invest conference, a panel of investment professionals looked at the changing world of commodities investing. As recently as a decade ago, it was difficult to get good data on commodity returns, complicating work on figuring out whether adding commodities to a diversified portfolio including other asset classes would provide better performance.

Since then, interest in commodities has mushroomed, and plenty of vehicles for trading commodities have appeared. From precious-metals ETFs SPDR Gold (NYS: GLD) and ETFS Physical Palladium (NYS: PALL) to broader commodity-index trackers such as PowerShares DB Agriculture (NYS: DBA) , it's easier than ever to invest directly in the commodities of your choice.

The problem with that ease of investing is that by bringing commodities into the mainstream, commodity ETFs have increased the correlations between commodities and stocks. That, in turn, has made commodities less effective as part of a risk-reduction strategy.

It's a small world after all
That phenomenon is nothing new. Whenever a new asset class has come into the fold, investors have jumped on it -- and thereby pulled correlations up.

For instance, about 10 years ago, real estate investment trusts gained in popularity as the tech bull market faltered. Many analysts touted the low correlations between REITs and ordinary stocks. But that correlation has gotten a lot higher recently, especially as popular REITs like Annaly Capital (NYS: NLY) and American Capital Agency (NAS: AGNC) have found themselves linked closely to the same interest rate cycle that helps drive stock valuations overall.

Similarly, investors used to avoid international investments, especially in small countries, as returns were extremely volatile. But, as Morningstar points out, the promise of diversification brought many investors into emerging-market stocks in the past decade.

The rise of Chinese Internet giant Baidu (NAS: BIDU) and Indian vehicle maker Tata Motors (NYS: TTM) -- as well as their availability on U.S. exchanges -- made them easy targets for investors seeking emerging-market exposure. ETFs such as iShares MSCI Brazil only added fuel to the fire. And again, as investors jumped into emerging markets, their correlations with U.S. stocks rose, reducing their effectiveness in diversifying investor portfolios.

Increasing correlation among asset classes actually makes a lot of sense, given the way the world has changed. Barriers to capital flows have largely evaporated, and money has flowed to wherever the returns are best. Moreover, because the global economy is more interconnected than ever, the old trick of escaping problems in one location or asset class by moving your money elsewhere has become almost completely ineffective. And from the perspective of the individual investor, innovations like ETFs have greatly increased the speed at which investors can shift their portfolios, removing inefficiencies that helped created low correlations.

Seeking real diversification
Diversifying your portfolio may be harder than it used to be, but you can still do it. It just takes a bit more work than simply picking a bunch of different broad-market index funds and counting on them not to move in lockstep. The best way to gain diversification is to seek out individual stocks that have competitive advantages over their rivals. Although a rising market may lift all stocks to some extent, the best companies should still excel over the long run.

Commodities may continue to see their prices increasingly linked with other types of investments, and that demands a second look at how you invest in them. If you expect them to save your portfolio the next time stocks take a dive, you may find yourself sorely disappointed.

If you like commodities, you need the best commodity stocks you can find. Read about a single tiny gold stock that's digging up big profits in this free special report from The Motley Fool.

At the time this article was published Fool contributor Dan Caplinger hopes he'll find a real, live bandwagon someday to jump on. You can follow him on Twitter here. He doesn't own shares of the companies mentioned in this article. The Motley Fool owns shares of Annaly Capital Management. Motley Fool newsletter services have recommended buying shares of Baidu. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Fool's disclosure policy gives you everything you need.

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