Larry Swedroe is a Principal and Director of Research of BAM Advisors Services, and one of the leading financial advisors in the U.S. He is the author of the forthcoming book, The Only Guide to Alternative Investments You'll Ever Need (Bloomberg, 2008), a book that explains the role of commodities, REITs and other alternative assets in a portfolio.  He spoke recently with the editors of HardAssetsInvestor.com about commodities, portfolio construction and the outlook for the U.S. stock market.

HardAssetsInvestor.com: A lot of people bought commodities over the past few years, and we've heard a lot of people who are upset that they didn't perform as advertised: i.e., rising in a falling market. Should investors stick with commodities?

Larry Swedroe: A lot of people made big mistake with commodities. They thought that commodities hedged all the risk of equities.  And a lot of people took the allocation they made to commodities from their fixed-income portfolios. That was a common mistake too.

The first thing you want to understand about commodities is that the reason to own them is to provide portfolio insurance. That's the only reason. You shouldn't buy them to enhance returns - no one can forecast returns or predict when commodities will produce strong absolute returns. You want to own them as portfolio insurance.

HAI: Which commodities are you talking about?  Gold? Oil?  Equities?

Swedroe: You don't want to own commodities directly, nor do you want to own the producers of commodities. The best bet is to own fully collateralized commodity futures that are not leveraged. We think the best vehicle is PIMCO CommodityRealReturn Fund, because they use TIPS as collateral, so you get a double real return in the portfolio.  TIPS should have a higher real return than short-term T-bills, and because you have the inflation hedge, you don't need to worry as much about duration risk – you can go longer, which boosts your return.

If you assume PIMCO is going to keep an average TIPS range in the 10-year space, they will pick up an extra 1.5% in real return compared to a fund that holds 3-Mo Treasuries as collateral. TIPS also have negative correlations with equities, while 3-Mo Treasuries have zero correlation, so it's better hedge for your portfolio.

HAI: But what about the people who did all this … who bought commodities and bought the right commodities, and are still down big on the year?

Swedroe: It is again about understanding how commodities fit in the portfolio. There are 8 period since the 1970s when stock returns have been negative. In six of the eight, commodities had positive returns when stocks had negative returns. And the average return during all eight periods, including the down ones, was plus 23%.

Commodities tend to have their best years when stocks do poorly. But they just have a tendency to deliver above average returns when stocks deliver below average returns, not a guarantee

If you think about the two periods when both stock and commodity returns were negative, 1981 and 2001, those were two very bad deflationary-type recessions. We had demand shocks to the economy, and commodities got hit at the same time stocks got hit.  The same thing is happening today. That is why you want to take the allocation to commodities from the equity side of your portfolio, because they can go down the same time as stocks. You need the fixed-income side of the portfolio to dampen the overall risk.

What's the best demand hedge? Long-term Treasury bonds. There are no periods when long-term bonds went down and commodities went down. By adding commodities and also extending the maturity of your bond portfolios, you gain some additional yield without increasing the risk of your portfolio, because those two assets hedge each other very well. That's the way to think about it. So many people think about assets in isolation, but you really want to think about it as part of a portfolio.

That's why I think you should still add commodities to a portfolio. Even this year, if you were rebalancing when commodities were sky-high, you're ahead. Really, even if you just held onto commodities, you're doing OK. The PIMCO fund is down 44%, and an all equity portfolio that includes international is down that much or more. So it hasn't hurt you, and if you were rebalancing, you're probably well ahead.

HAI: A lot of investors turn to gold for portfolio insurance, and not commodity futures. What do you think about gold?

Swedroe:  I don't see any reason to use gold. Inside commodities, you have some assets that have historically been in backwardation versus others that are easily storable and are in contango. Gold is easily storable, and it's almost always going to be in contango.

Assuming commodities have zero real return, if you invest in commodities, you should get the TIPS return plus a negatively correlating asset.  You should in theory be able to accept less-than-risk-free returns.  With gold, you're paying the contango. You can get a better return with commodity futures.

If you go back to 1979, gold hit $900/ounce. It's less than that today. You've had negative returns for 30 years.  If you had owned commodity futures during that time, you've probably had equity-like returns. So tell me why you would want to own gold? I can't figure it out.

HAI: What are your general thoughts about the economy and the stock market here?

Swedroe: The big picture is simply this: Clearly, this is the worst economic crisis we've seen since the Great Depression. But wait … did I tell you anything you didn't already know?  The markets know that too. This is the worst market since the Great Depression.

We all know the economic news is going to get worse. Unemployment is going to go up; retail sales are going to go down.  But while everyone's focusing on the bad economic news, they're forgetting that the market has already understood this.

People are saying, why can't this be another Great Depression? And it could; you can't rule that out. But what people fail to understand is this: In the Great Depression, the policy responses were all in the wrong direction. We raised taxes and raised interest rates, increased margin and reserve requirements, and started a trade war. The policy responses this time, whether you agree with it or not, has not only been in the right direction – cutting interest rates, flooding the markets with liquidity, etc. – but it has been the most massive effort ever. The effort is coordinated around the globe, and countries are pledging to maintain free trade. Every major country is enacting fiscal stimulus programs, all the central banks are cutting interest rates, etc. So while we have had a massive economic crisis, offsetting that is the largest policy responses in history coordinated around the globe. Policy responses take a while to work through the system, while the economic news will continue to look bad for a while.

Remember: Just when things look darkest, stock tend to have good returns. Prior to this year, when consumer confidence has fallen below 50, the average return for stocks the next year was 16%.

Or consider this: When unemployment rate is below 4.3%, the average return to stocks is 2%. When the unemployment rate is over 6%, the average return to stocks is 15%.

In the 11 recessions in the post-war era, the cumulative return to stocks is up 7%, and T-bills are up 5%. Returns were positive and better than the risk-free rate. Every time an investor sold stocks and paid taxes, they would have been better off sitting pat in stocks. The only way to do better would have been to forecast the recession, and who can do that?

I cannot guarantee that we will get out of this crisis, but we have gotten out of every other crisis quite well.