Commodities and Gold in a Portfolio

Gold gets more attention in a crisis than almost any other asset, and commodity funds are often sold as protection against inflation. Both claims hold some of the time and fail some of the time, and the way you buy a commodity can matter as much as the commodity itself. This chapter explains what commodities are as investments, what gold does and does not do, the hidden cost inside many commodity funds, how each route is taxed, and how to think about whether any belongs in your portfolio.

What you are buying when you buy a commodity

A commodity is a raw material traded in standard units: a troy ounce of gold, a barrel of oil, a bushel of wheat. Investors usually group them four ways.

• Precious metals: gold, silver, platinum, palladium. Gold is held mainly as a store of value; the others have large industrial uses too.
• Energy: crude oil, natural gas, gasoline. Prices swing with economic growth, weather and politics.
• Agriculture: grains, livestock, coffee, sugar, cotton. Prices follow harvests, weather and currency moves.
• Industrial metals: copper, aluminium, nickel, zinc. Demand tracks construction and manufacturing.

Unlike a share or a bond, a commodity produces nothing. A company earns profits and can pay dividends; a bond pays interest; a building collects rent. A bar of gold or a barrel of oil is worth only what the next buyer will pay. Over long periods, that means a commodity's price tends to roughly follow inflation plus or minus long swings in supply and demand, rather than compounding like a business.

The comparison shows why this matters. If $10,000 merely keeps up with inflation of 3.0% a year, it reaches about $20,938 in 25 years, which buys exactly what it bought at the start. The same sum compounding at 7.0% reaches about $54,274. These are illustrations with steady rates, not forecasts, but the gap is the cost of holding an asset whose job is to keep value rather than to grow it. The real return calculator converts any return into what it buys after inflation.

Gold: what it does well, and what it does not

What it does well. Gold has been accepted as a store of value for thousands of years, carries no credit risk (no company or government has to pay you), and has often risen during financial panics and periods when real interest rates were falling. Over very long periods it has roughly held its purchasing power.

Its limitations. Over periods that matter to a saver, gold's record is uneven. Its price can fall by half and take decades to recover in real terms; it did so after its 1980 peak. Its link with inflation is loose over periods shorter than many decades: research by Erb and Harvey, published in 2013 as "The Golden Dilemma", found the gold price has moved far more than inflation would explain, which makes it an unreliable short-term hedge. It pays no income, so holding it has an opportunity cost when interest rates are high. And it has occasionally fallen alongside stocks in the first stage of a crisis, when investors sell whatever they can.

Gold is best understood as insurance against specific bad outcomes (a currency losing value, a loss of trust in financial institutions), not as a growth engine. Like other insurance, its value is the protection it might give, and it has a cost when the bad outcome does not arrive.

The ways to buy, and the hidden cost of futures

Physical metal: coins and bars you hold yourself or store with a dealer. You own the metal outright, but dealers charge a markup over the spot price when you buy and pay below it when you sell, and storage and insurance add yearly costs.

Funds that hold physical metal: exchange-traded products that own vaulted gold or silver. They are cheap to trade and track the spot price closely, minus a yearly expense ratio.

Futures-based commodity funds: most broad commodity funds, and almost all oil, gas and agricultural funds, cannot store barrels or bushels. They hold futures contracts, which promise delivery at a set price on a future date, and must sell expiring contracts and buy later ones every month or quarter. This "roll" creates a return that can differ sharply from the commodity's price.

When later contracts cost more than nearer ones, a market condition called contango, each roll sells low and buys high, and the fund loses value even if the spot price stands still. When later contracts cost less (backwardation), the roll adds return. Contango is common in oil and natural gas, sometimes severe. Over the long run, research by Gorton and Rouwenhorst (2006) found that a diversified basket of commodity futures earned returns comparable to stocks, but much of that came from the roll and the interest on cash collateral, not from price rises, and those sources vary by era.

Suppose a commodity's price rises 5.0% a year. A fund holding the physical asset with a yearly cost of 0.3% turns $10,000 into about $15,905 over 10 years. A futures fund losing 3.0% a year to contango and fees ends near $12,190, about $3,715 less, on the same price path. In a strongly backwardated market the result would reverse. Always read how a commodity fund gets its exposure before comparing it with a price chart.

Producer stocks: shares of mining or energy companies. They are stocks first, affected by management, debt and costs, and often move more than the commodity in both directions. A broad stock index fund already holds them.

How each route is taxed

The tax treatment differs by route, and it surprises many investors.

• Physical gold, silver and other metals are "collectibles" under federal tax law. Long-term gains are taxed at your ordinary rate but capped at 28%, rather than the 15% or 20% that applies to stocks. Short-term gains are ordinary income.
• Funds that hold physical metal and are structured as grantor trusts are usually taxed as if you owned the metal: the same 28% collectibles cap applies to long-term gains. The fund's prospectus states its tax treatment.
• Futures-based funds structured as partnerships send a Schedule K-1 rather than a Form 1099. Their regulated futures contracts follow the "60/40" rule: 60% of gains are treated as long-term and 40% as short-term regardless of holding period, and gains are taxed each year whether or not you sell. Some commodity funds use other structures that report on a 1099; again, the prospectus says which.
• Mining and energy stocks are taxed like any other stock: qualified dividends and long-term gains at the lower rates.

Because the gains are taxed at higher rates or every year, commodity holdings are usually better placed in a retirement account where possible, as chapter 1 explains. Physical metal held in your own safe, of course, cannot be.

Deciding whether commodities belong in your portfolio

Most diversified portfolios hold no direct commodities at all, and many professional allocations treat them as optional. Those that include them typically keep them small, often in the range of 0% to 10% of the total, with gold the most common choice.

Arguments for a small allocation: commodities have sometimes risen when both stocks and bonds fell, especially in inflation shocks driven by energy or food prices, and gold has sometimes held value in financial crises. Arguments against: no income, long periods of poor real returns, high volatility, fund structures whose costs can quietly eat the return, and higher tax on gains.

If you decide to hold some, set a target percentage in advance and rebalance back to it. Commodity prices swing widely, so a fixed target forces you to trim after a surge and add after a slump, rather than buying because of a recent price rise. The rebalancing calculator shows the trades needed to return to your targets.