Commodities: Shiny & Pure

[This article appears in our May issue of ETF Report.]

I have to admit: I have a soft spot for commodities. In many ways, they’re the most perfect of all investable assets.

When I was in business school taking economics classes, the professor always used commodities as the case study. No other asset is as purely connected to the economy. Bonds carry a mountain of math and the unknowable uncertainties of defaults. And equities? Fuggedaboudit! Companies are subject to the whims of consumers, the foibles of human management and the constant barrage of headline news. But commodities represent supply and demand in its purest form.

They are also our most ancient form of finance. In the open markets of ancient Greece and Rome, buyers and sellers negotiated the terms of delivery for the coming harvest and they locked in prices. Today we’d call that a custom negotiated-forward contract. By the 1700s, that process became formalized by the Tokugawa shogunate at the Dojima Rice Exchange in Japan, and would be recognized as futures by any trader today.

Solving Problems
And really, the problems the modern markets are trying to solve aren’t all that modern:

• How can the farmer even-out her income stream?
• How can the cracker factory even-out its expenses?
• How can everyone manage the risk of a bad year?
• Where can I stash money in something that’s not cash?
• How do I store my physical goods for a proverbial rainy day?

These are, at the core, all commodity investors are doing—helping solve these problems. Most of us aren’t in the actual business of producing or consuming commodities except at the smallest level (we all consume energy and food, after all). But our participation in the commodities economy helps the system work, by providing liquidity and risk-taking.

When that farmer wants to sell her next-year corn and there aren’t enough natural buyers, the price will come down. When it comes down far enough, investors will step in and speculate that the price is “too low” and cause it to rise, thus giving the farmer a floor if she chooses to take the offer. That transfers the risk from the supply/demand side of the economy to the financial economy. And that, most would agree, is a good thing. It keeps the wheels turning.

Distorted Markets?
But not everyone has always been so excited about this. Going back all the way to the Japanese rice markets, politicians and pundits have always raised the prospect that the presence of financial-types in these transactions skewed the prices unnaturally, not allowing the economics of supply and demand to reset actual production and consumption to their natural levels.

And the ghost of famous “market corners” is always in the back of some minds, from Thales of Miletus cornering olive oil in Aristotle to the Hunt Brothers cornering silver in the 1980s to Sumitomo chasing copper in the 1990s.

Should we regular folks be concerned about these things? In my humble opinion, no. For regular investors, commodities represent a unique set of potential diversifiers that often provide an uncorrelated pattern of returns. Like any alternative asset class, a little can go a long way.

Just do your homework. And don’t annoy the shogun.