In the 1990s, commodities as an attractive opportunity were blips on few people’s investment radar. However, at the new millennium, with bond yields low and the tech stock bubble having burst, commodities started to attract more attention.
Investing in commodities appeared to provide a number of benefits, in particular: Attractive long-term positive returns and, because of the lack of correlation with equities and bonds, diversification. They also showed potential to protect against inflation. While commodities can certainly be used for “diversification purposes,” they are neither relatively easy to understand nor to invest in. We need only to look at recent markets to see this.
Academic and industry-sourced papers soon started to appear. For many, justifying a decision to invest in commodities was immediately made easier. Initially, the papers were enthusiastic, extolling the benefits of an investment in commodities.
One of the earliest, most enthusiastic and, at the time, conclusive academic pieces (still cited to-day by some proponents of commodities) was a working paper that appeared in June 2004, entitled “Facts and Fantasies about Commodity Futures” by Gary Gorton Wharton and K. Geert Rouwenhorst of Yale.
Using an equally weighted index of 34 different commodity futures and the period July 1959 to March 2004, the authors concluded: “In addition to offering high returns, the historic risk of an investment in commodity futures has been relatively low—especially if evaluated in terms of its contribution to a portfolio of stocks and bonds.” Furthermore: “Commodity futures returns have been especially effective in providing diversification of both stocks and bond portfolios.” They also showed commodities futures to be correlated positively with inflation, unexpected inflation and even changes in expected inflation.
Contemporary with their paper (it finally appeared in the March/April 2006 edition of the Financial Analysts Journal), an industry-sourced study entitled “Strategic Asset Allocation and Commodities, commissioned by PIMCO and conducted by Ibbotson Associated, was published in March 2004.
The findings of this study were equally positive. When using a fully collateralized total return futures index, “In addition to impressive historical returns, commodities had the lowest average correlation to the other asset classes; yet, the positive correlation to inflation supports the idea that commodities result in real inflation-adjusted returns.”
Tempered Optimism
But even then, some researchers sought to show that investing in commodities was not as simple as it seemed and that perhaps some of the reasoning behind the claims that had been made for commodities was worth further consideration.
For example, by the time Gorton and Rouwenhorst published their working paper in article format, they were obliged to include some important caveats, or ‘Directions for Future Research,’ together with their original conclusions.
Having extensively cited Keynes’s theory of normal backwardation in the working paper, not the least important of these directions was the following statement: “The Keynesian theory of normal backwardation whereby commodity producers pay to obtain insurance from investors may fit the context of undiversified farmers during the 1930s, but it has less appeal in the context of modern multinational companies operating in integrated global capital market, such as oil companies.”
A market in backwardation (or a backwardated market is one in which the futures price is lower in distant delivery months than in near delivery months. In other words the spot price (or expected future spot price) is higher than the futires price. Conversely, a market in contango (or a contango market) is one in which the spot price (or expected spot price) is lower than the futures price.
In September 2006, Harry M. Kat of the Cass Business School at City University in London published a particularly prescient paper, “Is the Case for Investing in Commodities Really that Obvious?”
He reported that over the previous few years, commodities had become ever more popular, often based on simplistic, and sometime specious, reasoning about supply and demand. Kat stated: “Supply and demand relationships in commodity markets are extremely complex and completely different for different markets.” And “even the experts are known to get it very wrong at times”—and still do!
Kat pointed out that Gorton and Rouwenhorst looked at only one specific portfolio (a different portfolio might have produced totally different results), and their study did not “account for the high degree of heterogeneity in commodities.” In fact, he wrote, one of the most important conclusions from a 2006 paper by Claude B. Erb, CFA, and Campbell H. Harvey titled “The Strategic and Tactical Value of Commodities Futures” and the two “What Every Investor Should Know About Commodities” papers he wrote with Roel Oomen in 2006 (all dealing with the behavior of individual commodities) was that, in fact, commodities do not offer investors a consistent risk premium.
Are the claims made for commodities still valid?
Few, if any, recent academic studies have revisited the role of commodities futures indices in a modern, diversified portfolio.
A couple of industry-sourced pieces on the subject, however, are of note: “The Role of Commodities in a Modern, Diversified Portfolio” by Mellon Capital which appeared in November 2008, and “Understanding Alternative Investments: The Role of Commodities in a Portfolio” by Kimberley A. Stockton of Vanguard, which appeared in August 2007.
While there is still cogent reasoning on each side of the continuing argument as to whether commodities offer investors a risk premium (and if they do, the nature of its consistency), it appears that commodities can still usefully diversify a portfolio because they continue to maintain a low correlation with other asset classes.
Earlier claims made for investing in commodities futures indices—their providing “high returns,” “impressive historical returns,” and “high equity-like average returns”—are less frequent now, not least following the in-depth study of individual commodities’ historic returns, the nature of those returns over longer (or different) time periods and rules that produce the indices in the first place.
But it has become increasingly apparent that for those using a passive, long-only futures strategy—whether using either indices or individual commodities—any expectation that roll return will continue to augment both spot and cash return is perhaps misplaced.
Positive roll returns are, of course, available only from markets in backwardation. In the last 10 or more years, however, markets in contango have become increasingly prevalent. In such markets, the ensuing roll return losses have either diminished the excess returns when positive or have augmented losses when the spot return has been negative.
This trend is unlikely to reverse, especially if inflation either remains a fear or becomes a reality. Moreover, the presence in the market of so much non-commercial, long-only money is unlikely to be helpful.
While commodities are still considered useful in providing protection against inflation, opinion remains divided about both the degree of protection they can provide and their reliability as an actual hedge against inflation.
But this hasn’t stopped massive recent inflows of assets into the commodities markets. On March 19, for example, after the Fed said it would buy some $300 billion of U.S. government debt, investors piled into a slew of commodities, seeking both protection against inflation and a hedge against a weaker dollar, and sending the S&P GSCI index up 7% that day alone!
Where Does That Leave Us?
Although commodities futures indices may not necessarily display all the same attractions they once did in terms of expected returns—or even as a hedge against inflation—they can still be attractive as a portfolio diversifier. For many investors, however, the question remains open whether—and how—commodities constitute an asset class. If they do, should they be grouped together with traditional investments, or should they be considered alternative investments?
Finally, however they may be used in a portfolio, to cite Kat’s words, “Commodities’ expected return is critical for the decision whether to invest in them or not.” For this reason, at least some understanding of the commodities themselves is vital. And therefore, it’s important to emphasize once again: Commodities are neither relatively easy to understand nor to invest in.
Thomas Butcher (thbutcher@me.com) is a New York-based financial writer.