Somebody's Making Money Off Commodities, But It Ain't You
by Eric D. Nelson, CFA
One of the most peculiar asset classes to pop up in the last decade or two has been “collateralized commodity futures”, or just “commodities” in common parlance. Commodity index funds provide investors with direct exposure to commodities futures contracts that rise and fall (mostly) in line with the underlying commodity.
If ever there was an asset class that illustrated what’s wrong with Wall Street and product-peddling/focused advisors, this would be it. Lets look at the claims and actual facts surrounding commodities.
Claim #1 - Commodities have stock-like returns.
Fact: We can’t be sure that commodity returns are anything more than 0%! There are two components to a commodity index: the performance of the commodities contracts themselves, and the return on the “collateral” you buy (because owning futures contracts only requires a small “down payment” freeing you to invest the rest of the intended payment in other instruments). The typical collateral investment is simply a three-month treasury bill, so comparing the returns of a standard commodity index with t-bills tells us how much comes from both components. And remember, you can buy a three-month treasury bill yourself at no cost.
Since the 1991 inception of the widely-followed DJ AIG Commodity Index, its returns have been been +4.3% per year, while three-month treasury bill returns have been +3.2% per year. Extending bond maturities from three months to just two to three years (“short-term”), on the other hand, increased returns to +5.2%. And looking at a globally diversified all-stock asset class portfolio, we find returns of +13.3% per year.
Unfortunately, the commodity index also had an annualized standard deviation (volatility) of 14.8, similar to stocks at 16.8. In comparison, short-term, high-quality global bonds stood at just 1.6. So it looks like there might be about a 1% per year return on commodities above the three-month treasury bill rate, but because the volatility is so high, we really have no idea if that’s the case. Over the last 10 years, for example (the period that corresponds with most people’s investment in commodities), the DJ index actually underperformed three-month treasury bills by 0.3% per year. Same goes for the beginning of the period—the index underperformed three-month t-bills by 0.8% per year from 1991-2001.
Claim #2 - Commodities provide excellent diversification.
Fact: There are much better diversifying asset classes elsewhere. If we look at the monthly correlations of the DJ AIG Commodity Index to stocks and bonds, we find no correlation with short-term bonds (-0.09) and a positive correlation with a globally diversified all-stock asset class portfolio (+0.39). With returns as low as we’ve seen from commodities, you’d hope to see strong negative correlations with stocks (say -0.3 or more). Alternatively, basic short-term, high-quality global bonds have provided much better diversification benefits to stocks than commodities, with correlations between the two of -0.16. And of course, stand-alone risk was much lower and returns were consistently higher for conservative bonds.
The downside of commodities really low returns, really high volatility, and a positive correlation with stocks can be seen by reviewing the 2008 bear market. From July of 2008 through February of 2009, a globally diversified all-stock asset class portfolio lost 49% of its value, while commodities lost over 54%! Short-term, high-quality global bonds, on the other hand, managed to squeeze out a positive 6% return.
Claim #3 - Commodities offer an inflation hedge.
Fact: Commodities are too volatile to hedge inflation, and other assets do this more reliably. The problem with commodities providing a hedge against inflation is that they are too volatile to do this reliably. Since 1991, the monthly standard deviation of the Consumer Price Index has been just a bit over 1.0. Commodity indexes are over fifteen times (!) as variable as inflation. You cannot possibly hedge something when your price movements are fifteen times as erratic as the result you are trying to overcome. It’s like trying to shoot a free throw while riding in a bumper car—the basket just sits there while you’re getting jostled all over the rink.
Instead, investors who want or need a hedge against unexpected inflation would be far better served to use Inflation-Protected Bonds. Every six months, their returns are credited the trailing Consumer Price Index rate, so they reliably track inflation movements. Longer-term TIPS also contain a volatile interest rate component, so that risk should be considered relative to safer but lower-expected returning short-term TIPS.
Of course, TIPS do have very low expected returns (lower than nominal bonds of the same maturity because they avoid the risk of unexpected inflation), but they are still higher than three-month treasury bills. We cannot conclusively say the same thing about commodities. And one more caveat about TIPS: they may not provide the same level of risk reduction as traditional bonds. In the period from July 2008 to February 2009 mentioned above, TIPS declined by about 7%.
Short-term, high-quality global bonds are another reasonable alternative for inflation-sensitive investors also looking to more consistently lower the volatility of an all-stock portfolio. While their returns don’t track the consumer price index as closely as TIPS, it’s expected over time that their interest rates will rise and fall with the prevailing rate of inflation and provide investors a small real return and a consistent premium over cash (three-month treasury bills).
So commodities don’t have stock-like returns, they aren’t great diversifiers, and investors looking for inflation protection should look elsewhere. There is, however, one group who commodities are great for. And that’s investment managers. The giant bond manager PIMCO, for example, currently has over $16B invested in their commodity mutual funds, with fees ranging from 0.75% for the institutional class share, to 1.2% on the “D” share available through mutual fund supermarkets like Charles Schwab, and almost 2% per year on the broker-sold “C” shares. A back-of-the-envelope calculation puts the annual advisory fees to PIMCO at something north of $16M per year to roll futures contracts, buy a bunch of bonds (as the collateral), and provide exposure to an asset class that probably won’t do any better than a bank CD. That’s a good job if you can get it!
You, on the other hand, don’t have to fall for that nonsense. Stick with traditional stocks and bonds and a portfolio that reflects the purpose of your wealth. And by all means, skip the “alternatives” like commodity funds...because somebody’s making money off them, but it ain’t you!
Source of data: DFA Returns 2.0
Globally Diversified All-Stock Portfolio = 20% S&P 500 Index, 20% DFA US Large Value Index, 30% DFA US Small Value Index, 10% DFA Int'l Value Index, 10% DFA Int'l Small Value Index, 10% DFA Emerging Markets Value Index, rebalanced annually.
Short-Term, High-Quality Global Bonds = Citigroup World Government Bond Index 1-5 Years (hedged to US $)
TIPS = Barclays TIPS Index
Three-Month Treasury Bills = BoA Merrill Lynch Three-Month Treasury Bill Index
Past performance is not a guarantee of future results. The returns and other characteristics of the allocation mixes contained in this article are based on model/back-tested simulations to demonstrate broad economic principles. They were achieved with the benefit of hindsight and do not represent actual investment performance. There are limitations inherent in model performance; it does not reflect trading in actual accounts and may not reflect the impact that economic and market factors may have had on an advisor’s decision-making if the advisor were managing actual client money. Model performance is hypothetical and is for illustrative purposes only. Model performance shown includes reinvestment of dividends and other earnings but does not reflect the deduction of investment advisory fees or other expenses except where noted. Clients’ investment returns would be reduced by the advisory fees and other expenses they would incur in the management of their accounts. Past performance is not a guarantee of future results, and there is always the risk that an investor may lose money. Indexes are not available for direct investment.