A Short Guide To Commodities Investing

January 24, 2015

UCEndowmentUsesPassiveAvtiveBlendInvestors have traditionally turned to commodities because of their diversification effects and as protection against inflation. Often considered to be real assets, commodities perform very differently from other asset classes over the economic cycle, historically providing low-to-negative correlations with stocks and bonds. In addition, they provide substantial protection during periods of crisis, such as wars and stock market crashes. Commodities have been attractive because they don’t always behave like more traditional assets, but they can come in vehicles—such as futures—that don’t look much like those used to access traditional assets. So how should an investor approach commodity investing?

Lately, commodity returns have disappointed, with asset prices sagging this summer and inflation remaining below the Federal Open Market Committee’s 2 percent target. In addition, they dropped sharply during the worst of the global financial crisis. But over the longer term, the Merrill Lynch Commodity Index has outperformed inflation, global equity and hedge fund benchmarks from the end of 1997 through June 2014, as can be seen in Figure 1.

MakingEquityIndexesRelevantForLocalInvestors

A Good Diversifier
Commodities’ long-term benefits are well-documented: In an award-winning paper, Claude Erb and Campbell Harvey found that commodity futures that periodically rebalance can offer similar expected returns and historical Sharpe ratios as equities, in their view based largely on the diversification effect of combining individual commodity futures in a single broad index. The paper, which was published in the Financial Analysts Journal,1 also found substantial support for the inflation protection capabilities of certain commodity futures, e.g., heating oil, copper and cattle.

Commodities’ diversification effect is apparent in the last 15 years, producing low correlations with other asset classes—only 0.44 to equities and 0.17 to sovereign bonds from January 1999 to July 2014, as can be seen in Figure 2. Relative to a classic 60/40 portfolio of U.S. stocks and bonds, commodities has only a 0.3 correlation—slightly higher than the 0.2 correlation of inflation-protected bonds, but lower than the 0.6 correlation of U.S. real estate to the balanced portfolio.

MakingEquityIndexesRelevantForLocalInvestors

 

 

Not only have commodities been a good diversifier, but they have tended to perform well during periods of rising inflation. Commodities returned 28.2 percent versus 6 percent for equities and real estate, and 2.9 percent for bonds in inflationary periods (defined as when the month-over-month inflation rate increase exceeded 0.1 percent) from January 1998 to June 2014.

Accessing Commodities
Investors basically have three choices when looking to invest in commodities: physical assets, derivatives and equities.

Investing directly in commodities represents the purest exposure to the asset class, but it has a severe drawback: The cost of actually holding and storing physical commodities is prohibitive. How many bushels of wheat can you store in your garage? Where do you put that tanker car of oil or herd of cattle? Perhaps an investor can hold a small amount of gold, but it is generally impractical for the vast majority of investors to hold physical assets. In addition, there often are high transaction costs involved in buying and selling physical assets.

Investing in commodity futures, one type of derivative, is more practical for most investors. They can obtain exposure to commodities without incurring any storage or insurance costs, while obtaining a diversification effect and hedge against inflation. But futures can be daunting for individual investors because of their complexity. They can be risky due to contango and backwardation—situations that can lead to potential losses that do not reflect changes in the underlying spot commodity prices.

Contango occurs when the price of a futures contract is trading above the expected spot price at the expiration of the contract. Thus, a contract in contango normally declines in price, so an investor who is going long buys the contract at a higher price than the roll price—the proceeds from the sale will not be enough to buy a new contract going forward. Backwardation (or normal backwardation) is the opposite: The price of a futures contract is trading below the expected spot price at contract maturity. Backwardation can generate extra profits for investors, often called a “convenience yield.” The risk in investing in commodity futures is that, depending on how the spot price changes during the time the investor holds the futures contract, she might lose money.

The third option is to invest in stocks of companies that are either commodity producers or companies that have a strong relationship to commodities. While this approach is less direct, it offers several advantages over investing in physicals and derivatives. Investing in commodity-related stocks provides exposure to equitylike total returns. It also benefits from long-run equity growth, such as dividend income and capital appreciation. In addition, investors can invest in active as well as passive approaches, depending on their investment philosophy.

Regardless of what investment option investors choose, these days they can obtain exposure to commodities via exchange-traded products (ETPs)—wrappers that may simplify or reduce some of the potential drawbacks of each option. For example, ETPs are created and managed professionally by pooling of physical commodities, futures or equities that may track a well-known benchmark. In the United States, investors can access commodities through these vehicles:

  • physical commodities via ETPs—professional managers are responsible for buying, selling and storing the actual commodities
  • derivatives through commodity ETFs, which may use futures contracts, swaps or other derivatives to gain and manage desired commodity exposures
  • equity from commodity equity ETFs, which offers exposure via producer equities through either sector-driven indexes or screened production criteria
  • commodity exchange-traded notes, which offer exposure to broad-based, sector or single commodities

Investors have been drawn to commodities for good reasons: Historically, they have been strong diversifiers and have performed particularly well during inflationary periods. While inflation has been very low in recent years, at some point the global economy will revive. Investors would do well to consider where commodities fit into their portfolio. Once they do, they need to ponder how to best access this unique asset class.

Endnote
1 Erb, Claude B. and Campbell R. Harvey, (2006), “The Strategic and Tactical Value of Commodity Futures.” Financial Analysts Journal, vol. 62, No. 2: 69-97. See also Gordon, Gary and Rouwenhorst, K. Geert, (2006) “Facts and Fantasies about Commodity Futures.” Financial Analysts Journal, vol. 62, No. 2: 47-68.

 

 

Find your next ETF

Reset All