The Right Stuff

When it comes to investing in commodities, I don’t recommend them to my clients for one simple reason: I don’t understand them well enough.

The first rule of investing is to never invest in something you don’t understand. Don’t get me wrong, I know what commodities are and I’ve done enough research to form an opinion. I just don’t understand enough to know specifically what to expect from commodities in the future or to have any confidence that the asset class will provide an adequate return on investment.

Commodities are essentially “things.” They are inputs to other products, such as oil or steel. They can also be things we consume like agricultural products, or precious metals like gold which does not have much intrinsic value. Things don’t produce any income, so there is no reason to expect a high return from “stuff.” There are no cash flows to consider or fundamental analysis to perform. This leaves only speculation as a way to value commodities.

If stuff is scarce, the price will go up. It’s a simple case of supply and demand. This involves speculation, because it is exceedingly difficult to predict future supply and demand conditions. For example, energy has performed well in the past, but that does not say anything about the future. Technological advances have, and will continue to shape the need for energy, as well as the amount and type available.

The table in my office is an input to my financial planning process, so in a sense, it could be considered a commodity. With that said, I don’t really want to invest in office tables. The price for the table could go up in the future. I could possibly sell it on eBay, and someone might be willing to pay me more than I paid for it, but there is no rational reason to expect someone to pay more.

As a group, commodity prices should track very close to inflation, but most do not provide any real return above inflation. This makes sense, because rising prices of things are what constitute the bulk of what we call inflation. Therefore, one element of the return on investment from commodities is the change in prices.

Investors don’t actually buy commodities directly. Nobody wants to wake up one morning to find a truck load of pork bellies in the driveway. Commodities are purchased through a futures contract, which gets closed out before the product ever gets delivered. They are a way for producers to lock in current prices, even though the delivery date could be months away. For instance, a wheat farmer might be happy with the current price of wheat and be concerned the price at the time of harvest could drop. He might use a futures contract to make sure that he gets the price he wants, even though he could be giving up an opportunity for a higher price.

As long as they are paid for providing this insurance, speculators are willing to take the other side of the transaction. They get paid for the risk they take in order to hedge the risks for others. Hence, there’s the potential for a return on investment in commodity futures contracts separate from general price inflation.

While the actual prices might follow one path, the contracts could be reacting quite differently. Esoteric terms like backwardation, contango, and roll yield are used to describe the process and the effect of futures contracts that expire and get replaced with other futures contracts at different prices. The end result is that an investor in futures contracts could earn a profit or take a loss.

Separate from the potential investment return, there is a potential diversification benefit from adding commodities to a portfolio of other assets. The asset class has a low correlation with stocks and bonds so rebalancing between commodities and other investments can generate a positive effect.

Within the broad category, there are also many different commodities. Prices will change at different rates and possibly different directions. Buying an ETF that tracks a broad commodity index will get some return from rebalancing between commodities.

The combination of diversification within the asset class and between asset classes can have a positive effect on a portfolio. The main advantage is reducing volatility, so that you enjoy the psychological benefits of a smoother ride with the overall portfolio. That is, your stocks might dip, but your position in commodities might cushion some of the shock. Even so, the mathematics of diversification shows that a smoother ride can also slightly increase the rate of return on a portfolio.

The favorable effects of diversification and rebalancing are offset to some degree by additional costs. Commodity funds typically are more expensive than stock or bond index funds, because there is a cost of carrying the physical commodities underpinning the process as well as the insurance cost of using futures contracts.

Financial experts have lined up on both sides of the debate. Respected authors and advisors, Roger Gibson and Larry Swedroe, find the diversification benefits to be compelling. Other notables like John Bogle and William Bernstein think that the performance of the past will not be repeated and that diversification alone is not sufficient. When you toss into the mix the added costs compared to other investments, and the fact that commodities are not very tax efficient, it’s a tough sell to these experts.

It’s not about choosing sides, though, it’s about doing what is right for my clients. This becomes especially difficult when you don’t know for sure who is right. Ultimately, it’s a judgment call. You’re heard many times that past performance is no guarantee of future performance. In my judgment, this disclaimer is particularly relevant with regard to commodities. In fact, there is strong evidence that future performance will be much lower than in the past. Lacking confidence in the future rate of return leaves me evaluating commodities mainly based on their diversification value.

Even though commodities have a low correlation with other assets and can often cushion the losses from other investments - in times of great financial distress like in 2008 - all risky assets tend to drop at the same time. This means that the portfolio insurance that you buy with a commodity ETF could fail you when you need it most.

Moreover, I’ve never seen anyone with a very large percentage of their portfolio in commodities. For those who advocate for including commodities, the recommended amounts are usually in the range of 5% to 10% of the portfolio. While this will help temper the overall volatility of a portfolio, it’s not enough to make a huge difference.

When I look at the totality of the commodity issue, I’m not convinced that the advantages outweigh the disadvantages. Commodities are not essential for a portfolio, so why include them with the associated drawbacks? Ultimately, the decision comes down to the fact that I don’t really understand them. For me, commodities just don’t have the right stuff.