The prolific author and investing expert shares his insight on the best ways to approach the commodities markets.
Last week, we learned that commodity futures had finally pulled ahead of stocks in the performance race. But are outsized returns really what investors should seek from their commodity exposure? Or should hard assets play a subtler role in a portfolio?
That's why we went to Larry Swedroe, principal and director of Research for the Buckingham Family of Financial Services. Known as a voice of reason in the investing community, Swedroe is a prolific author and one of the most respected financial advisers in the business today. His book on commodities and other alternative asset classes, The Only Guide To Alternative Investments You'll Ever Need, was published by Bloomberg in 2008, and he has two more books on the way soon.
Recently, HAI Associate Editor Lara Crigger chatted with Swedroe about the role commodities play in a portfolio, including whether it's worth chasing commodity returns, why he's sworn off ETNs for good and why he remains skeptical about active commodity ETFs.
Crigger: Last time we had you on the site, you talked about the usefulness of commodities as a hedge, or an insurance against supply shocks. But do you think commodities can actually add returns to your portfolio as well?
Swedroe: The historical evidence is this: Commodities have no real expected return, nor should they. Commodities are an input to economic activity, if you will. Therefore, they should have very low expected real returns.
In the long term, they do serve as a reasonable inflation edge, although not a perfect one. There's no guarantee. Just take gold. It was at $300 or so in '82, and 20 years later it was still $300—and we averaged 4 percent a year inflation. So for that 20-year period, you lost 4 percent a year. So in that sense the evidence shows that [even over a] pretty long period, commodities don't even act as a good inflation hedge.
That's why, in our previous discussion, I had suggested that commodities should only be used as a means to provide a hedge against some kinds of event risk that can hit either stocks or bonds badly. They can be supply shocks, wars, political risk, those kinds of things.
Regardless, you should expect very low correlation between the returns on commodities on average and the returns on your other portfolio options. So it does provide a diversifier, but it's one with a very low expected return. But because of its high volatility, a small allocation to commodities is going to have a significant impact on the returns of a portfolio. Commodities may not deliver great returns, but their impact on the portfolio is bigger than just the return of the asset class itself, which is the mistake many people make. But the only right way to look at things is: When you add an asset to a portfolio, how does that impact the risk and return of the overall portfolio?
Crigger: You're a big advocate of using futures over stocks to get your commodities exposure. What are some of your favorite ways to tap into commodity futures?
Swedroe: The reason I like futures over stocks is that the correlation of commodity producers' stocks [to the broader stock market], while not that high, is still significantly positive. It's higher than it is to the commodities themselves. With futures, there's much lower correlation, and you get away from the risks of equities themselves, since obviously the stocks of commodity producers contain exposure to beta risk.
Right now I think that you should have either the Goldman Sachs or the Dow Jones UBS indexes. Historically the data shows if you added either one, basically you'd have higher overall returns. But my own personal preference would be to use the Dow Jones Index, because it's less weighted toward the energy sector and oil.
Crigger: Yes, the GSCI is about 70 percent in energy.
Swedroe: Right, so you're more diversified across the broad commodities spectrum [with the DJ-UBS Index]. If you're trying to hedge inflation at all, you want a broad commodity index.
Secondarily, because of the amount of money going into commodity futures, it may have changed the structure of futures prices, so we're seeing more persistent contango in bigger numbers. That tends to show up in not-easily-storable commodities like oil (as opposed to easily storable commodities, like gold). Therefore you want to minimize your exposure to those, because you'll be paying big contango prices. So the Dow Jones has less weight there and therefore would have less drag on it.
And then you've got to consider all the other things: What's the collateral the fund uses? And the expense ratio? And other things. It's a complex question.
Crigger: When you're looking at commodity products, do you prefer ETFs over ETNs?
Swedroe: No one should ever use an ETN.
Crigger: Really? Why is that?
Swedroe: They make no sense. To me, the reason is this: They're priced as if there is no credit risk. Anyone should have learned the lesson, but people's memories are incredibly short—what if you'd bought an ETN with Lehman Brothers?
Crigger: In fact, Lehman had a few out there when it collapsed.
Swedroe: So you're taking on the credit risk, and you're not compensated for it. Now you do have the tax advantage, but if you're an institutional investor it's irrelevant—you're not taxed generally. If you're an IRA or ROTH retirement plan, you don't need the ETNs either, because you don't need the credit risk. If you don't have room in a tax-advantaged account, then I don't think it's worth the costs that end up being incurred to get the tax benefits. There are other ways that are more efficient.
So in other words, if you can't hold commodities in a tax-advantaged account because you don't have room, then don't use ETNs. Let's say you have an ETN from Barclays; look at the long-term credit spread of Barclays over Treasurys—I don't know what it is, but let's say it's 1.5 percent. Well, that's an incremental cost, but once you add it to the cost of the ETN, then the ETN makes no sense. It's the point at which the costs of diversification are not worth the benefits of an asset class.
Crigger: Then why are commodity ETNs still so popular?
Swedroe: People don't understand what I just told you. They don't see it because it's not an explicit cost, but an implicit cost they're not charged for. It comes back to the way people make decisions about investment vehicles. There are hidden parts that the average investor doesn't see, or is unaware of, because they don't read all the fine points in the 10K. You have to look at the total picture in making a decision: turnover, securities lending revenue, tax efficiency—and the same thing is true with ETNs. Just because you're not charged for the credit risk doesn't mean you're not bearing the cost.
Crigger: We've seen new ETFs take more and more of an active approach to commodities lately. There's the SummerHaven Dynamic Index, which judges its futures positions based on inventories, and then we've got the S&P Commodity Trend Indicator, which is momentum based, and so on. As a fan of indexing, do any of these more active strategies appeal to you?
Swedroe: Well, that's a little bit of a tough question. First, I'd say that anything based on fundamental analysis, I would ignore. I don't believe that that adds up, because if so, it means that somehow you have more knowledge and are smarter than the market.
Now there is a paper by Erb and Harvey that found if you go long on the commodities that are in backwardation and short the ones that are in contango, you actually add value. So it's generating alpha. Now the problem is if you do that, I think the whole argument for commodities goes away, since in my mind, the only reason to own commodities is as an insurance hedge.
Let's say oil is trading in contango. So now you're short. And there's a war in the Middle East, and the Strait of Hormuz get blocked, and oil jumps overnight to $150/barrel. Your equities get hit, your bonds get hit and now you're short oil. You get killed. So I think that example blows away that argument for owning commodities in the first place.
There's also evidence for a momentum effect, but of course obviously if everyone starts trading on momentum, it goes away. So I'd be very leery about anything other than active management of the roll dates, which I think does make sense.
Crigger: In your Wise Investing column, you've been recently writing about overconfidence. Do you think that the commodities markets tend to draw in overconfident investors?
Swedroe: I don't think it's necessarily a question of overconfidence, although that's probably a component. I think that's much more a recency story. For most people, their emotions get in the way. They get caught up in greed and envy when asset classes are going up, so they buy high. Then they get caught up in fear and panic when they're going down, and they sell low.
The way to enact "buy low/sell high" is something that's easy in theory and difficult in practice: rebalancing. All you have to do is have a well-thought-out plan that forces you to sell high and buy low. The key to successful investing is to have a well-thought-out plan. You have to act like the lowly postage stamp, which does one thing and only one thing exceedingly well: It adheres to its letters. So you need to adhere to your asset allocation by rebalancing.
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