[Editor's Note: Dennis Tilley is research director at Merriman Berkman Next Inc., a Seattle-based consultant and advisor.]

Do commodities have a rightful place in a broadly diversified portfolio? The obvious answer seems to be yes, they do. However, after a lot of careful study and thought, we have concluded that the right answer is still no, they don't.

Commodity prices across the board are at all-time highs. Experts say the world is running out of natural resources and that production will not keep up with the rising demand from fast-growing emerging economies.

From a portfolio point of view, commodities also have attractive characteristics. While commodity prices are quite volatile, they tend to zig and zag independently of stock and bond prices. Due to the uncorrelated price movements, adding a small amount of commodity exposure can actually lower overall portfolio risk for a given expected return.

There is also a small measure of portfolio insurance gained from commodity exposure. During a rare commodity-related crisis, such as the Arab oil embargo in 1973, a dramatic rise in commodity prices will help buffer the decline in both stocks and bonds. Commodity exposure can also provide some insurance against political risk, since many of the nations currently rich in natural resources also tend to be somewhat politically unstable.

For all of the reasons briefly described, we were keenly interested in adding commodities to our model portfolios. This was a hard problem with many subtleties and conflicting expert opinions to work through. Contrary to our expectations, after careful study, we recommend leaving commodities out of a diversified investment portfolio.

Here is a quick summary of why we made that decision. First, we expect long-term investment returns of commodity funds to be less than that of ultrasafe T-bills. Second, adding commodity funds to our value and small-tilted equity portfolios lowers expected investor returns. Finally, we believe that our well-diversified equity portfolio offers plenty of exposure to energy, basic material, and emerging market stocks that stand to benefit directly from commodity inflation. For more details, please read on.

Investing In Commodities

How do you go about investing in commodities? One way is to purchase the actual commodity and store it yourself. Over time, your wealth will grow as commodity prices rise—hopefully by a lot, thanks to China and India. However, there are a few serious issues with this approach, and you may want to finish this article before restocking the wine cellar with barrels of light sweet crude.

I'll highlight just a couple of problems. First, storage costs are high for even a modest investment. For instance, at a current price of $95/barrel, a modest $10,000 investment in crude oil would require a small warehouse to store all the barrels. To diversify into copper, livestock and grains is just as impractical.

A second problem is that commodities don't pay dividends while sitting in a warehouse. There is an opportunity cost of having your money tied up in copper bar stock, when you could easily invest your money in ultrasafe T-Bills. Storage costs, opportunity costs, insurance costs and trading costs all can eat a huge chunk of potential returns out of a "physical" commodity investment approach.

Commodity Funds

To relieve these problems, financial services companies have developed new exchange-traded funds (ETFs) and exchange-traded notes (ETNs) that use futures contracts to gain exposure to commodity prices.

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