What are commodities, anyway?
Commodities are a non-correlated asset class that fights inflation. Or are they? What do commodity funds actually own? Do you want them in your portfolio?
Food prices are rising, and extreme weather is the new normal. Gas prices keep climbing. Every year there are more mouths to feed. Surely there must be a way to make a buck on these indisputable trends?
Read on to learn if the facts match the hype, and to get my thoughts on commodities in your portfolio.
“My God! The Dukes are going to corner the entire frozen orange juice market!”
Who can forget the guys that put commodities on the map? I’m talking about Eddie Murphy and Dan Ackroyd in Trading Places:
(as they approach the New York Mercantile Exchange, ready to corner orange juice themselves and beat Randoph and Mortimer Duke at their own game)
Louis Winthorpe III: Think big, think positive, never show any sign of weakness. Always go for the throat. Buy low, sell high. Fear? That’s the other guy’s problem. Nothing you have ever experienced will prepare you for the absolute carnage you are about to witness. Super Bowl, World Series – they don’t know what pressure is. In this building, it’s either kill or be killed. You make no friends in the pits and you take no prisoners. One minute you’re up half a million in soybeans and the next, boom, your kids don’t go to college and they’ve repossessed your Bentley. Are you with me?
Billy Ray Valentine: Yeah, we got to kill the motherf… – we got to kill ‘em!
Commodity futures – how old timey farmers got paid
Back in the day, commodity contracts were simple arrangements with grain and meat buyers that included some standard terms plus a delivery location and date.
Oscar Mayer put up cash, and Joe Rancher delivered pigs and cows on schedule.
Commodities boom
Commodities were a backwater until the end of the tech bubble, when PIMCO and other institutional investors turned a spotlight on them as a new asset class.
The sales pitch: commodities have the returns of equities and are un-correlated, meaning they don’t crash when equities crash. This makes them a great addition to portfolios. Plus they also fight inflation.
Bubbling up to the Great Recession
Assets in commodity funds grew from $13 billion in 2003 to $180 billion in 2008. Wow!
Could that insane increase in commodity assets have had anything to do with the 150% returns to commodity mutual funds during that 5 year period?
During a similarly frothy half-decade, the NASDAQ composite inflated from 750 in 1995 to 5,000 in 2000 before losing 80% of its value during the 2001-2002 recession.
Commodities bust
During the Great Recession, the S&P 500 declined 40%. What happened to commodities, which were supposed to be un-correlated? QRACX, PCRAX, GSG, and other commodity funds lost 70% of their value. Wow again!
Still, commodities funds returned from 26% – 40% in the last 12 months, and they are buzz-worthy once again.
Commodities have been touted as inflation-fighters and counter-cyclical diversification. But what exactly are they?
What commodity funds actually own
Commodity funds do two things with your money: buy bonds, and make bets using the bonds as collateral.
The bonds they buy with your money deliver returns to you: interest taxed as ordinary income.
The bets are just bets
The bets on commodity futures are just bets: they either win or lose. If the bets lose, the fund sells your bonds and pays the winner. If the bets win, the fund takes your winnings, buys more bonds, and makes more bets.
The specific bets that commodity index funds make are simple:
- Buy a crude oil future. This is typically a contract that will deliver oil in one or two months.
- Sell the contract just before it expires. The buyer of the contract will get real oil that they can haul away and burn up.
- If oil went up, you win your bet. If it went down, you lose.
- Settle your bets, buy more futures, and repeat.
The index fund therefore owns a rolling portfolio of futures contracts – a kind of permanent bet on oil prices increasing.
Uh Oh – Contango
Because commodities are actual stuff that needs to be transported and stored, futures contracts normally get cheaper as they get close to maturity. This problem for commodity funds is called contango, and it is a cost that must be overcome by the winning bets.
Normal contango can range from 1% for gold which is dense and therefore easier to store, to 5% or more for stuff like grain and oil.
Imagine if owning stocks had a carrying cost of 1-5%. Would that hurt stock market returns? It would bury them.
One reason passive investing crushes active is because active investors face a kind of carrying cost in the form of taxes on short term capital gains.
Making money on commodities
There are four sources of gains in commodity funds:
- Interest and capital gains from the bonds
- Inflation in the basket of commodities
- Price appreciation OVER inflation for the commodities
- Rebalancing if commodities have low or opposite correlation to equities
(1) The gain from the bonds
The bigger commodities funds, especially the $25 billion PCRAX, have capitalized on this hidden source of value creation.
These “commodity” funds have been taking interest rate risk by owning intermediate-term bonds. As interest rates fell over the past decade, these funds made capital gains on their bonds. This has ended now that interest rates are so low.
If interest rates rise in the future, these funds will get hurt.
(2) The gains from inflation
What should the relationship be between commodities and inflation? In theory they should be the same, since inflation is defined as the rise in price of a basket of commodities!
Unfortunately, betting on commodities is a lousy way to hedge against inflation because commodities are very volatile. TIPS (Treasury Inflation-Protected Securities) are US government bonds that offer inflation protection with low volatility.
(3) The gains from price appreciation
If the commodities you’ve chosen are different than those that comprise inflation, then you can earn gains or losses different from inflation.
Unfortunately for investors, this is impossible to figure out in advance, but you can fake it.
“Get the amazing returns of the Goldman Sachs Commodity Index!!”
Goldman Sachs was the first to identify this recipe for profit (for them, not for you)
- Use historical data to find a combination of commodities that would have been a huge winner, had you owned it for the last 10 years.
- Justify your back-tested combination with some vague prose. From the website: “The index is calculated primarily on a world production-weighted basis.”
- Attach your brand. Call it the “Goldman Sachs Commodity Index” (GSCI).
- Create financial products with high management fees, and have advisors sell them to consumers as an inflation-fighting asset class that is non-correlated with stocks. QRACX, one of the oldest to track the GSCI, has a 1.96% expense ratio, of which 1% is kicked back to your financial advisor as a hidden 12b-1 fee. Perfect!
- Sell the whole thing to Standard & Poors when the juice is mostly gone, as Goldman Sachs did in 2007.
There are now multiple different commodity indices, all weighted differently based on how the back-testing turned out when each index was created!
It works for Goldman, but not for you
In a 2004 study, researchers looked at returns to the Goldman Sachs Commodity Index before and after it was created in 1991.
The Goldman commodity index “returned” 9.6% annually from 1970-1990 (i.e. before it existed), but only 2.8% annually from 1991-2004. Meanwhile, the S&P 500 was returning 12% annually, and Small-Cap Value returned 21% annually during that same 1991-2004 period.
Note that annual returns since 2004 for commodities have been even worse, excepting only the last 12 months.
Merrill Lynch – “Most Shameful”
I’ve taken clients from Merrill Lynch. Their portfolios are terrible, and their tactics are shameful.
In 2006, Merrill Lynch launched their own back-tested commodity index. Here’s how they depicted their returns versus the other popular indices in a brochure dated September 2006.
The fat red line is the Merrill Lynch Commodity Index.
Back-testing didn’t prove so hot for Merrill’s clients. No investment vehicles currently track this index – it’s dead.
(4) The gains from rebalancing
In order for a lower-returning asset class to improve portfolio returns, it needs to have either very low volatility, or be oppositely-correlated with equities, or both.
Bonds have low volatility and are often oppositely correlated with equities – that’s why my clients own them.
Commodities have very high volatility, about twice that of equities, and they are increasingly correlated to equities.
Commodities become “financialized”
Professors Wei Tang (Remin U, China) and Wei Xiong (Princeton) note an interesting result in Index Investment and Financialization of Commodities (Nat’l Bureau of Economic Research, Sept 2010).
The correlation between different commodities, and between commodities and stocks, once so low, has grown in lockstep with the increase in commodity mutual fund assets. In other words, commodities have become “financialized” and they now move up and down together with stocks.
Let’s sum up
- Commodity funds are not as attractive as they first appear.
- The past returns overstate the expected future return.
- They are too volatile to be an effective inflation hedge vs alternatives
Your Porfolio
Owning commodities means owning less stock, and we need really good reasons to own less stock and bonds because companies create value and grow wealth, whereas corn, cows, and crude oil are just stuff we consume.
A correctly constructed portfolio of stocks and bonds with judicious use of high-yield fixed income an an appropriate small-value tilt has the greatest likelihood of creating the most wealth in an uncertain future. That is what I build for clients, and it is what you should own for yourself.