Director of Alternative Investments

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 ultra-safe 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 ultra-safe 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 (ETF) and exchange traded notes (ETN) that use futures contracts to gain exposure to commodity prices.  A sampling of the more popular funds is shown in the table below.  Also listed are three open-ended mutual funds which have been around longer, but are only available with front-end loads or load-waived via an advisor. 

As of 9/30/07, commodity funds’ one and five-year performance numbers have been great, comparable to the S&P 500.  Three and ten-year annualized returns don’t look that great - this variability and lack of consistency is an illustration of the high volatility associated with commodity funds.  Commodity funds also have higher fees than typical equity and bond index funds (for the latter two, expense ratios range from 0.1 to 0.4%).

Table 1.  Comparison of Commodity funds (as of 9/30/07, data from Morningstar).

How do these funds work?  Commodity funds hold a fully collateralized, diversified portfolio of commodity futures contracts.  The portfolio weighting of each commodity is typically held in proportion to its share of the annual world production of all commodities.  Since oil, and oil-based products, make up a significant portion of all commodity indices, commodity funds are heavily influenced by the price of oil. 

What does fully-collateralized mean?  It’s a technical way of saying that commodity funds do not exploit the leverage that futures contracts offer.  For every $1 of commodity exposure purchased via futures contracts, $1 is invested in T-bills serving as collateral. 

Futures contracts also expire over time.   Before a futures contract expires, the contract is sold and the proceeds are “rolled over” to the next nearest futures contract (typically a month out). This rolling process occurs every month.

These funds solve all of the problems associated with the physical commodity approach.   First, just like any mutual fund, the pooling of many small accounts allows the fund to take advantage of scale.  You are instantly diversified, there’s no need for a warehouse, and transaction costs become very small compared to the asset base.  A second important benefit of commodity funds is that the T-Bills used as collateral are earning interest.  There is no opportunity cost penalty with commodity funds.

Interestingly, back-testing of this strategy has shown one further addition to returns that occurs from the rolling process.  Historically, on average, futures prices tend to be higher when sold compared to the purchase price.  Depending on the time period, estimates of the roll return range from 1-5%/year.  In theory, commodity funds provide the roll return in addition to interest from T-bills and the return from the change in commodity prices. 

Unfortunately, there are a few important and subtle drawbacks associated with commodity funds.  Wall Street loves subtleties - that is how they make money from Main Street. 

Drawbacks

At first glance, the commodity funds have solved all the problems associated with investing in commodities.  Why not include them?  For us, the fundamental question is:  what is the long-term expected return of commodity funds?  We believe commodity funds will deliver long-term returns similar to that of T-Bills minus management fees.  An asset class doesn’t belong in a portfolio if the expected return is less than ultra-safe T-Bills.

Why do we believe this?  Ultimately, a futures contract is just a bet.  There is a winner and a loser.  This is a fundamental difference between commodities funds and asset classes with real returns, such as stocks, bonds and real estate. 

Equity investing is win-win.  As an equity investor, you supply capital to a company with the expectation of achieving a return that is higher than T-Bills.  Otherwise, you wouldn’t make the investment.  It’s a risky investment, and you may lose all your money.  Yet by diversifying among thousands of companies, it is reasonable to expect a long-term return that is higher than T-Bills.  Likewise, a company accepts your investment because they expect the value of the company will increase at a rate better than T-Bills with further investment.  It’s win-win.  We can also express similar arguments for bonds and real estate.

When a commodity fund purchases a futures contract, the institutional trader on the other side of the transaction also knows about the growth story of China and India.  The trader knows about peak oil theory.  The trader will not purchase or sell a futures contract at a price that doesn’t fully account for all the fundamental reasons to be long commodities.  This is the first subtlety associated with these investment vehicles.  Commodity funds will not benefit from a long-term secular rise in commodity prices if market participants already expect it to occur.

Here’s another way of looking at this.  Over the short-term (days or weeks), essentially all the price movement is unexpected, and we see commodity funds rise and fall pretty much in synch with commodity prices.  The subtlety is that over the long term all unexpected movements tend to cancel each other out – leading to no expected return above T-Bills due to commodity price inflation.

What about the roll return?  An enormous amount of money has streamed into these commodity funds in recent years.  As you might expect, when there are many insurance providers (commodity fund investors) going after an existing pool of insurance seekers (commodity producers), profits (the roll return) will shrink.  Actually, commodity producers also know the emerging market growth story and may decide that they don’t need much insurance after all.

The roll return has indeed trended lower over the last few decades.  While back-testing suggests that a roll return was present in the past, the more investors become aware of a profitable trading strategy, the lower future returns.  Unfortunately, we have not found a long-term mechanism to support a positive roll return in the future.  At some point the roll return may even turn negative, indicating that holders of the commodity funds are now the ones paying for insurance to protect the portfolio from commodity price spikes.

The win-lose aspect of commodity futures contracts, the reliance on historical back-testing, and the mechanical approach of buying and selling contracts each month, suggest that commodity funds are not really an asset class at all, but a commodity futures trading strategy.

The bottom line is that we expect the commodity funds to provide a long-term gross return that is roughly equal to T-bills.  From this expected long-term return, we can subtract management fees (~ 1%) and most likely hidden transaction costs associated with turning over the portfolio once a month.

Commodities or Equities?

Another more practical issue is that in order to add commodities to the portfolio, we must take from something else.  It doesn’t make sense to carve out a piece from bonds, since commodity funds can easily be down 30-40% in a single year.

So the allocation must come from equities.  Even if we assume that commodity funds provide a small return premium compared to T-Bills (after fees), the long-term return expectation is still much lower than that of an equity portfolio that’s tilted toward value and small cap stocks. 

The difference in expected return can be large, on the order of 4-5% per year.  Adding a 10% slice to commodities lowers expected equity portfolio returns by 0.4-0.5% per year.  Granted overall portfolio risk may be reduced slightly, but most people will not boost their equity exposure when adding commodities – thus, for all practical purposes, their expected returns are hurt by adding commodities.

Summary

The bottom line regarding commodity funds is that we believe long-term expected returns will be lower than T-Bill returns.   Even though the correlation with stocks and bonds is small, no asset class belongs in a diversified portfolio if it has a return expectation below T-Bills. 

There are better inflation hedges and ways to play the rise in commodity prices.  Ultimately, the best exposure to commodities is through equities; our recommended equity portfolio offers plenty of exposure to energy and basic materials stocks and to asset classes with heavy exposure to commodity production, such as emerging market stocks.  Although not perfect, TIPS and short-term treasuries also provide some protection against a commodity price spike.

Commodity funds have done well over the past few years.  Think back to 1999 during the height of the NASDAQ bubble, and maybe you’ll remember that no one was thinking about commodities at that time.  Oil was priced as low as $12/barrel in 1999.  Much of the commodity fund returns over the past 10 years is due to a rapid rise in expectations for commodity inflation.  This is a one-time benefit.  At this time, with all the attention commodities are receiving in the press, it’s difficult to believe that expectations for commodity inflation will continue to rise as fast in the next 10 years. 

I’ll admit that I’m opening myself to look foolish on this conclusion because I could be very wrong over the next decade.  The volatility of commodity funds can make an advisor look like a hero one year and a goat the next year.  However, our decision to avoid commodity funds is consistent with an efficient markets view and our long-term approach to designing portfolios.