The Dirty Secret Of Commodity Investing

Negative returns have had much more to do with low cash interest rates than investors would expect  

Reviewed by: Peter Sleep
Edited by: Peter Sleep



Why has commodity investing been so disastrous for exchange traded product investors over the last five years? The answer is pretty straight forward, and not one that investors might expect. Commodity investing has been disastrous because cash interest rates have been so low.

Yet consultants and academics continue to recommend that investors diversify their portfolio by allocating to commodities. Academic papers point out that historic commodity returns have been on a par with equities, but were uncorrelated. Commodity ETPs developed in the marketplace and were an instant hit as portfolio managers became well-marketed talking heads on the growth in China, the emerging middle class demographics and global warming-induced food shortages, all boosting demand for commodities in the face of potentially dwindling supply.

What Are You Actually Invested In?

However, a careful reading of the academic papers shows that consultants and academics did not recommend commodities themselves, but commodity future indexes instead. The dirty secret of commodity investing is that half of the historic returns from commodity investing came from cash, with the other half from the annual rebalancing of the commodity indexes or the “rebalancing premium”, found in some smart beta products.

The returns from commodity futures were alluring. Papers noted that, depending upon the start date and end date, investing in commodity futures can give you a return in excess of the S&P 500 over time. A paper by investment consultancy firm Ibbotson in 2006 looked at the period 1970 to 2004 and concluded that a portfolio of commodity futures returned 12 percent a year compared to the S&P 500’s 11 percent a year, with similar volatility.

Strong Returns Prove Tempting

Further, Ibbotson noted that even in the eight years when the stock market fell, the annual return to commodity futures was over 19 percent annualised. There were two negative bond years, where the Barclays U.S. Aggregate Bond Index had annual returns of minus 2 percent, whereas commodity futures returned a stunning plus 21 percent.

From a consultant’s point of view, what is not to like? Here we have an asset class that has strong returns that also behaves well when stocks and bonds go backwards. The consultants’ optimisers loved commodity future indexes and they recommended a good sized weighting in all portfolios across the risk spectrum.

However the back testing was performed over a period when cash rates were exceptionally high and as a result, half the return of commodity futures came from cash collateral.


How Do You Generate Returns From Cash?

When you invest in a future, you have to post a little bit of cash margin, but you are left with a lot of cash which can be invested in cash deposits or, more typically, three-month U.S. treasuries. It is this cash that provides about half of the commodity futures’ return historically, with the other half coming from a rebalancing premium, or buying low and selling high on a consistent basis to rebalance your portfolio. The Ibbotson research paper found that of the 12 percent commodity return, over 6 percent was the return cash.

No Real Inflation Protection?

There is an argument that commodity investing is a great hedge against inflation, as commodities are real assets - things you can touch like property or art, as opposed to financial assets like bonds or stocks. There may be some truth in this argument in the long term, however, the link between commodity futures prices and inflation is weak at best and they are only related insofar as cash interest rates and inflation are linked.

There is also a theory that you can earn a return from the spot increase in the price of commodities and from the roll return of commodity futures, or as some call it, “the convenience yield”. However, there is scant evidence that there is any excess return from these factors. As Claude Erb and Campbell Harvey say in their review of commodity futures returns: “[…] nothing in the historical record gives investors comfort that future spot and roll returns will be substantially positive.”

With the ongoing blood bath in the commodity markets, it seems unnecessary to point out that commodity investing was at best a two-way bet. Performance has been dictated by three month U.S. interest rates. Whisper it quietly to the ETP providers: even before the commodity rout started, investing in this sector during a low interest rate environment was always going to be difficult trade.


Peter Sleep is a senior portfolio manager at Seven Investment Management