Should you gold plate your ISA?

Samantha Downes wonders if commodities are a wise choice for the ordinary investor

Seemingly unstoppable rises in the prices of gold, oil, wheat and other foodstuffs have caught the attention of investors in recent years. Of course, institutional and specialist investors have a long history of betting on the price of the commodity rather than the commodity itself. These include derivatives such as futures and options which bet on whether the spot price of the commodity goes up or down.

A commodity is generally considered a basic resource or an agricultural product such as iron ore, crude oil, coal, salt, sugar, coffee beans, soybeans, aluminum, copper, rice, wheat, gold, silver, palladium, and platinum. Commodities also include energy sources, including electricity, gas, coal and oil.

The term soft commodities generally refers to those resources that are grown, while hard commodities are those that are mined.

You do not have to be a commodity specialist to benefit from some of the more spectacular rises – nor do you have to have to go out and buy the commodity itself.

Dennis Hall, a chartered financial planner and owner of Yellowtail Financial, said: "While you can buy physical gold, such as coins and gold bullion, you can't put that in an ISA wrapper."

Edward Johnson at the brokers Willis Owen, said the value of commodities is often unrelated to more conventional asset classes, such as equities, which means they can provide a useful diversification in your portfolio. But you have to do your research.

Chris Jacques, chief investment officer at the asset manager Eden Financial, said: "It is worth choosing to include commodities in your portfolio, but we would recommend you look at buying the shares of companies which benefit from either the commodity's extraction or production."

Danny Cox, of Hargreaves Lansdown, said the main demand for commodities has been driven by emerging markets such as China and Russia.

He added: "Investing in a commodities fund is really an emerging market play. So if you have an emerging markets exposure, you need to blend your commodity investments with that."

Because their prices are often unrelated to markets and macroeconomic factors, commodities are far more volatile than equities.

"This does put off investors," said Mr Coc. "Any commodity-related investment can add as much 35 per cent, compared with equities, which tend to add around 20 per cent volatility to the typical portfolio."

The volatile nature of commodities, – because their price changes on a day-to-day basis – means they are not a short-term bet. Mr Jacques said: "Gold has been volatile but has also made people a lot of money. We often say gold has two different personalities. With banks printing money, now could be a good time for gold as many investors use it as a hedge against inflation, but then gold has also done well in times of deflation."

There are, aside from physically investing in the metal or foodstuff, two main ways of buying commodity exposure. The first is by buying into an investment that is linked to the price of the commodity. This could be via an index, such as an exchange traded fund or a structured product.

But Mr Jacques said such indexes were often too opaque for many investors to understand.

For most ordinary investors, he said, the best way is through equity markets, buying a share in a company which benefits from an increase in commodity prices.

"We would suggest buying into the price of gold via buying mining equities rather than spot gold."

The same goes for oil. "You don't have to invest in BP. You can instead look at companies that supply the nuts and bolts, the service providers who allow BP to drill in the first place, such as Petrofac, which is listed in the FTSE 100."

In the UK, oil services companies are listed in the blue-chip FTSE 100 index and also in the midcap FTSE 250 index.

Many of the shares in the index – such as Wood Group – have been undervalued because of the recession.

Graham Spooner, of the Share Centre, said: "Investors wanting to invest in commodities are also looking at blue-chip mining companies like BHP Biliton or Randgold. Companies that supply services to mining companies are also proving popular, such as Weir Group, Amec and Hunting."

Mr Johnson said for most investors, general commodity funds may be a more appropriate method of exposure.

"Investing in individual shares as part of a self-select ISA may not be appropriate for many investors. There are some well-known funds which have exposure to commodities."

He added: "The benefit of investing in these funds is that their manager will be constantly monitoring the wide variety of issues that impact on the sector and can respond as necessary. An investment fund also spreads the risk by providing a degree of diversification, as they will generally invest in a variety of commodities."

Mr Johnson recommends two commodity funds – the BlackRock Gold & General fund, run by Evy Hambro, and the Investec Global Energy fund.

"These appear in our 2012 ISA guide," he said. "Both are specialist funds, so are potentially riskier than a cautious or balanced fund, but also potentially offer greater returns."

The BlackRock fund allows investors access to gold mining and precious metal-related shares, while the Investec fund aims to provide investors with long-term returns, primarily through investment in companies around the world that are involved in oil and gas exploration and production. This fund is also up more than 40 per cent during the past three years.

Another perennial fund often suggested by advisers is the JPM Natural Resources fund.

Managed by Ian Henderson, it has returned 700 per cent in the last 10 years. However, it does have a volatile history.

It may be worth considering up-and-coming commodities, but these are specialist and investors are advised to seek the advice of an independent adviser.

Mr Cox said: "While gold has appeal as a store of value and is often seen as a 'safe haven', there are other commodities, such as copper, which is seen as more of a barometer for economic prospects."

The price of copper is notoriously volatile, but its value has increased in recent years.

"Copper has widespread uses, particularly in power and construction. It is an excellent electricity and heat conductor, used in cars, transport and communication systems, even mobile telephones and coins," Mr Cox said. "Huge amounts are being used by industrialising economies such as India and China, and fluctuations in demand are therefore used to indicate future manufacturing activity in these countries.

"It is also worth mentioning that in the US, for example, some decades ago aluminium began to replace copper in wiring American homes, but was later removed after fires resulting from poor connections."

Many investors will be investing in commodities without realising it.

Mr Jacques said: "Remember that any Russian index will already be heavily correlated to oil prices because it is such a large producer."

Investors with an exposure to China will also be benefiting from a rise in the price of oil and gold.

"If you have market exposure to China, you need to be aware that the performance of Chinese stocks and the gold price are inextricably linked.

"It's an emerging market play. So you are not diversifying if you are buying China and commodities.

"You need to blend your commodities exposure with any emerging market exposure you hold."

He would also advise any investors to carry out their due diligence.

But not all advisers are convinced that commodities should be included in an ISA.

Yellowtail Financial's Mr Hall said: "I don't think consumers understand commodities enough. They are hugely volatile. You won't be doing wrong by investing a small part of your ISA in commodity-related stocks, but you have to accept volatility.

"With a commodity, particularly a mining share, it relies on the price of whatever it is extracting. That said, there is the potential of a mining company to discover a seam of gold or an oil reserve. Then that share price will go up, hence the volatility."

He believes investing in commodities is a long-term play, and investors will have to live with their choice.

Joel Barrett, an adviser with Barretts Financial Services in Bishop's Stortford, is wary.

The recession has meant a plethora of undervalued stocks across all sectors and that is where he feels investors should be looking.

"At the moment, there are enough undervalued shares, and while commodities can play a part in a balanced portfolio, some commodities are at an all-time high. For example, there is only so much oil, and it will get to the point where oil is so expensive people will turn to solar panels.

"You could say many of the profits have already been taken from commodities, particularly oil and gold."