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Originally published Saturday, May 21, 2011 at 10:00 PM

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Your Funds

Expect commodities to bring volatility to fund portfolio

Average fund investors who decided a year or more ago to take a chance on commodities funds have found out recently what all the warnings and danger signs were about.

Syndicated columnist

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Average fund investors who decided a year or more ago to take a chance on commodities funds have found out recently what all the warnings and danger signs were about.

Now the question is how they intend to deal with trouble.

Prices for commodities have risen dramatically over the last year, with a wide range of factors pushing the trend. Many investors used commodities to hedge against a weakening dollar and the threat of inflation. Others liked the story of growing worldwide demand, especially from emerging markets, and then there was the turmoil in the Middle East and its potential to change the supply picture for oil.

No matter the reason why an average investor looked to inject commodities into their portfolio, they were rewarded for the choice. The average broad-basket commodities fund returned about 40 percent more than the Standard & Poor's 500 over the last 12 months, according to investment research firm Morningstar. No one was complaining with annualized average returns well north of the 20 percent line.

But no one ever complains when the volatility is to the upside. If the Dow Jones industrial average gains 1,000 points tomorrow, investors will party; if the market drops 1,000 points — same move, different direction — bolt the windows.

And over the last month or so, commodities have shown that their volatility is not just to the upside.

Silver, among the biggest gainers in the commodity uprising, fell 27 percent in the first week of May alone, after hitting a 31-year high. Oil prices dropped 15 percent in the same week.

Over the last month, commodities funds suffered double-digit declines that have since bounced back. But few investors signed up thinking they would see their funds drop 7 percent in a month, about the commodities fund average as calculated by mutual-fund research firm Lipper.

This is the time in investment cycles where average fund investors typically make their biggest mistakes. Unlike the sharpies who are in early on market moves, the average investor was late to decide that they needed more exposure to commodities than they might get through their ordinary fund. In fact, they were content with the average fund until they saw the oversized gains commodities were putting up.

At that point, they decided it was time to make "an allocation decision." They weren't buying commodities to get the hot asset class — because average investors don't see themselves as timing or chasing the market — they simply felt that the story was so good and the diversification benefits so strong that they needed to commit a piece of their portfolio to it.

Now, however, they're reacting to the volatility and price drop. Measures of fund flow show the money racing out of commodities funds, which means that someone who bought into the rally well after it started invested high, and is now selling low.

"If you are allocating the appropriate amount toward commodities — no more than 10 to 15 percent of the total portfolio should be in commodities because they are so volatile — then you should just leave it in place and don't try to time things," said Holly Hooper-Fournier, editor of the Mutual Fund Strategist newsletter, which uses mutual funds to implement timing strategies.

"That's hard for the commodities investors who were late to the game. They did not have the benefit of the run-up of the last 12 months. They bought in recently because of the story, and now they're getting a timing sell signal, or they're just feeling the volatility because it's against them, and they want to blow up their strategy."

"The story is still, roughly, the same," said Walter Frank, chief investment officer for Moneyletter. "You are buying commodities on the premise that global growth ultimately will show up in demand for commodities, meaning that you will do reasonably well in the long run.

"The people who do spectacularly well playing commodities, well let's just say that's not the average guy buying a commodities mutual fund. So if you've got a commodities fund, you play the fundamentals and try to ignore the ups and downs, no matter how spectacular those moves can be sometimes."

Ignoring the downs is never easy, as investors in commodities funds are finding out now.

In fact, those swings are readily visible in the performance charts, where Lipper shows the average commodities fund with an annualized gain of 16.4 percent over the last 24 months, but an annualized loss of 12.25 percent over the last three years.

Over the last 10 full calendar years, the average commodities fund was up in seven of them, but the two biggest moves (both well over 30 percent) were to the down side.

"Ask yourself why you got into commodities in the first place," said Jeff Tjornehoj, senior research analyst for Lipper. "If you bought in because you felt your portfolio was not capturing the full market of securities, then you should have known that there is no free lunch and that the run would not go on forever. Backing away now would just reopen that hole in your portfolio. And if you have commodities in their proper place — so that they are a smaller portion of your overall holdings — there's just no reason to panic."

Chuck Jaffe is senior columnist for MarketWatch. He can be reached at cjaffe@marketwatch.com or

Box 70, Cohasset, MA 02025-0070.

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