In my 2011 outlook post earlier this month I mentioned that I had raised the cash portion of my portfolio to 40%. I did this by selling out of my commodity positions. A recent post I read at Pragmatic Capitalism reminded of me of this and that I should explicitly talk about it here on the blog. I highly recommend reading Cullen’s entire post but I’ll just use some highlights from it here to make my point.
In general, I don’t view commodities as investments in the classic sense. They are a speculation pure and simple relying on selling your position to someone else at a higher price. As Dylan Grice from SocGen points out;
“The fluctuations of commodity prices have fascinated speculators for hundreds of years, but why should investors be interested? Commodities aren’t productive assets, so how can they create wealth over time? And why should they provide investors with a collectable risk-premium? Commodity returns can be decomposed into the “spot” return and the “roll” return. It’s not obvious to me that either are dependable sources of compoundable profit.”
And, over time, they have been an absolutely horrible investment.
In general, an investor wants to be in productive, income producing assets. That doesn’t mean you can’t make money in commodities. There have been many commodity bull markets in history as the chart below makes clear.
So, making money in commodities requires a different approach. An investor needs to either time commodity markets or use some other risk management strategy. Lets take a look at how commodities have done since 1973, pretty close to the start of the major commodity bull market of the 70s. Here are major asset class returns since 1973:
First thing to notice is that even in this commodity bull market the returns have not been that great and the volatility has been extreme. An investor would have been much better off in bonds. If you used the timing model I’ve described before, based on the 200 day moving average, then your returns would have been higher and risk much lower.
But still the returns are not that great given the volatility and the fact that commodities pay no income. For retirees in particular this doesn’t make them very attractive. If that is the case, why do so many money managers and financial planners recommend allocating a portion of your portfolio to commodities. Ah, that is when we get into the theory behind asset allocation. Asset allocation basically is supposed to work by investing in multiple asset classes, since no one can predict future returns, that have low to negative correlations. Ideally you want one asset to zig while the other one zags. When one assets zigs, has positive returns, you sell some of that asset, and invest it on one that zags, has negative returns. This is called rebalancing. This produces good returns because you are basically buying low and selling high. And commodities have historically had negative correlations with stocks. But is this still true?
The rise in popularity of commodities started giving me pause late last year. Given the lack of income stream from commodities the only reason for me to invest in them would be for diversification, for those negative correlations. So what is the correlation of commodities to stocks? The typical, off the cuff answer is that the correlations are negative. I decided to find out for myself. Here is the rolling 12 month correlation of the S&P500 to the GSCI Commodity Index over the last 3 years.
Not pretty. For some reason the correlation of commodities to stocks has gone from negative to very very positive over the last 3 years. And I bet the correlations to emerging market indexes is just as high or even higher. The high correlations pretty much remove the diversification advantage of commodities. One potential reason for this is the popularity of these investments and Wall Street’s drive to offer more of these investments to the public. Cullen in another post makes this point.
Since the crash of the Nasdaq bubble investors have found commodities as a reliable alternative to equities despite the asset classes poor historical performance. This non-correlated asset class has become the perfect sales product for Wall Street. Over the last 10 years Barclays says the investor class allocation towards commodities has increased from $6 billion to $320 billion and that’s excluding hedge funds.
In short, higher positive correlations, poor historical long term performance, non income producing assets spells a bad long term investment to me and I think for most income investors. When I opened my commodity positions in early 2009 I did so because I thought the crash had taken their prices down too far, and I thought they would bounce back nicely. I also bought into the diversification hype. I held the positions in a risk protected vehicle, a structured product with no downside, which removed my concerns over their volatility. They were a trade, not an investment. In hindsight, they were a decent investment, but I would have been better off in income producing assets, either stocks or bonds.
I don’t think I’ll be investing in commodities again. If I want commodity exposure, because I think the prices are too low, I’ll do it through companies with commodity price exposure, whether it be oil companies, mining companies, etc… This way an investor can get an income stream, commodity exposure, and active human ingenuity maximizing the value of the investment.
Part of being successful in investing is constant learning and questioning the conventional wisdom. I think today’s conventional wisdom on commodities is wrong in particular for income oriented investors and retirees. There is no question you can make money trading commodities but they are not good long term income investments. And that is why I’ll never invest in commodities again.
Full Disclaimer - Nothing on this site should ever be considered advice, research or the invitation to buy or sell securities. These are my personal opinions only.