Revisiting the investment case for commodities

By David Peartree
The Daily Record Newswire

Are commodities an asset class worth owning? We posed that question a few years ago and found the case to be inconclusive at best. Since then the case for commodities has not become any stronger or more compelling, anything but.

The theoretical case for commodities as a portfolio asset gained traction about 10 years ago based on a study published in 2005, "Facts and Fantasies about Commodity Futures." As investors we tend to think of commodities as physical stuff oil, soybeans, and the like but note that the study is about commodity futures. That's because the only practical way for investors to gain commodity exposure is through commodity futures contracts.

Few investors can invest in physical commodities directly; it's too expensive and impractical. Investors are forced to take the indirect route using commodity futures. A futures contract is an agreement to buy or sell a specified amount of a given commodity at a fixed price at some future date.

Actual commodities are tangible stuff. Futures are intangible, and that's how the case for commodities gets complicated.

The 2005 study cited several key findings in favor of commodities: 1) their stock-like returns, 2) lower volatility than stocks, and 3) a negative correlation with stock performance (a good thing for portfolio construction). It turns out, however, that past was not prologue. It appears that the commodity futures market may have changed significantly over the past 10 years.

For the 45 years ending Dec. 31, 2004, covered by the study, commodity futures were in a persistent and profitable trend called "backwardation" where expiring futures contracts could be replaced by less costly futures contracts, thus giving investors a source of return. Since then, futures contracts have been in a persistent and unprofitable trend called "contango" where expiring contracts have to be replaced with more expensive contracts. That is a drag on returns.

The commodities market has undergone other changes since 2005 that have not helped the investment case. Until around 2005, commodity futures were largely the domain of the producers and buyers of physical commodities. The traditional commodities futures market was essentially an insurance market that allowed the players to hedge against future price swings.

Starting in the mid-2000s numerous commodity linked exchange-traded funds (ETFs) were launched, making this market much more accessible to investors. While that sounds like a good thing, greater access may have changed the dynamics of the futures market to the detriment of investors.

At the end of 2005, investors had about $5 billion in commodity ETFs. By the end of 2010, commodity ETFs held about $125 billion. Poor returns and some outflows have pulled that number down a bit, but it's still estimated to be around $100 billion.

It appears that investment flows into commodity ETFs have bid up the prices of futures contracts, creating a drag on returns. At the same time, spot prices in physical commodities have fallen, a further drag.

Commodities are supposed to help a portfolio by producing higher returns at a lower risk. Recently, however, Morningstar reported its conclusion that over the past 15 years, the contribution of commodities to a portfolio would have been lower returns and higher risk.

Apart from changes in the commodities futures market, another challenge for the case for commodities is the complicated nature of their returns. Uninformed investors assume that changes in physical commodity prices, the "spot prices," drive returns. Not so.

Physical commodities have no expected real rate of return. Spot prices have historically been a drag on the returns from commodities futures. The long-term real return from physical commodities over the past 130 years has been, at best, flat.

Any long-term returns attributable to commodities appears to come from the trading of futures contracts and depend on whether the market is in "backwardation" and produces a positive "roll yield" or is in "contango" and produces a negative "roll yield."

Some studies argue that the most significant source of returns from commodity futures is neither the spot price nor the roll yield, but the return from the collateral (often U.S. Treasuries) posted by the seller to back up the contract.

Good grief. If there is an investment case to be made for commodities it is not straightforward or compelling. Commodity futures look increasingly like a speculative trade and less like a viable long-term investment.

Here is a simpler thesis for investors to consider. If you want equity-like returns, invest in stocks and, perhaps, real estate. We know what drives their returns.

And if you want to protect your portfolio with an asset that has a low correlation with stocks, invest in high quality U.S. bonds. High quality bonds have historically been one of the best diversifiers of equity risk, better certainly than commodities. Bonds have been so maligned in recent years that their fundamental merit, portfolio protection, tends to get overlooked.

We can take further evidence as it comes, but for now the investment case for commodities is unconvincing.

-----

David Peartree, JD, CFP® is the principal of Worth Considering, Inc., a registered investment advisor offering fee-only investment and financial advice to individuals and families. Offices are located at 160 Linden Oaks, Rochester, NY 14625, david@worthconsidering.com.

Published: Mon, Oct 19, 2015