Major Flaw #1: Low Returns and High Volatility—Why Would I Ever Invest in Commodities?

The bottom-line reason to own commodities is because they are biased to outperform when you really need them to. This holds true even though the average returns over time may be unattractive. A perfect analogy is insurance, which tends to share similar characteristics. Insurance protects you in the event of a disaster (be it a fire, an accident, death, or whatever you are insuring against). If the event you are insuring against doesn't occur, you lose a little by owning insurance, since you have to a pay a premium to stay insured. You can think of commodities in the same way. Even if the total excess return above cash is very low over the long run, you still benefit from owning it because it pays off during periods in which your other assets may be doing poorly (particularly during rising inflation economic climates). The higher the inflation relative to expectations, the more it earns. When considered from this perspective, a low average excess return over time actually makes it even more attractive than insurance. Insurance has a negative return almost all the time and probably a net negative expected return to you over the long run even if it does pay off every now and then (which is precisely why insurance companies exist and are highly profitable). Think of it as insurance that you do not have to pay for. The same rationale applies to TIPS, Treasuries, and every other asset class. Each is there to protect you in a different economic environment. Even stocks are there to protect you against periods of rising growth and falling inflation. You may not feel you need protection against these encouraging periods, but owning stocks protects your portfolio from potential underperformance of the rest of the assets. They all work together and have a specific role. This important concept will be more fully fleshed out later in this chapter when I discuss the role of commodities in a balanced portfolio.

Major Flaw #2: Two Structural Issues—They Pay No Income and Futures Prices Can Diverge from Spot Prices

Commodities produce no income. Your return is based solely on the difference between the price you pay to buy and the price when you sell. Most other asset classes, such as equities, Treasuries, and TIPS, offer interest or dividends in between buying and selling, providing an additional source of returns. Even stocks and bonds that pay no dividends or interest accrue some value while they are being held. Companies earn profits, and if they choose not to pay a dividend they simply reinvest the cash into their businesses. This theoretically adds some value that benefits shareholders. A zero coupon bond that does not pay interest compensates investors with a gradually increasing bond price until it reaches its full par value at maturity.

That commodities produce no income should not dissuade you from including commodities in your balanced portfolio. Due to the pronounced benefits of this asset class's unique characteristics, it is still worthy of a place in a balanced portfolio, regardless of the aforementioned issue. The bottom line is that value is less important than its economic bias. And since there is a scarcity of good inflation hedges, commodities can add value when included in portfolios. The response to this objection will become even more evident when we go through how commodities fit within the context of a balanced portfolio later on.

Another concern involves the unique structure of commodities futures. The apprehension stems from the fact that the spot price of the commodity can rise, but you may still lose money depending on the shape and slope of the futures curve. In reality, you are not investing in the current price of a commodity. Since you are buying a commodity futures contract, you are effectively making a bet on the future price and how that future price may change. Consider the following example: oil today is $100 per barrel and the futures contract three months from today is $102. If you buy the three-month futures contract and during that period oil rises from $100 to $102, then you do not gain anything. This is because you bought a contract for $102 (even though today's price was only $100). Therefore, even though you were right that oil went up $2, you were not able to profit from this foresight since you effectively had to overpay for the investment. The opposite, as argued, is also true. If the futures price is lower than the current price, then that makes investing in commodities a more attractive endeavor. This is the thinking among many market participants.

Although this logic may seem intuitive, it misses a big component of how you should think about investing in commodities futures. Remember that the return you earn from any investment, not just commodities, is based on how the future transpires relative to what had been expected and already factored into the purchase price. I discussed this notion in the section that noted that Treasuries may produce attractive excess returns even though the starting yield is low. The reason for this, as I explained, is that the concern that interest rates may rise (because they are low) is probably already priced into the yield curve. Said differently, longer-term Treasuries offer a higher yield than shorter-term bonds and cash because of the expectation that interest rates are going to rise. This is reflected in an upward sloping yield curve that may be very steep. Your excess return above cash will depend on whether interest rates rise more or less versus what is already discounted. Thus, if everyone expects rates to rise and they actually rise less than the level priced in (but they nonetheless rise), you earn an excess return from holding long-term Treasuries because the increase was less than expected.

A commodities futures curve and the return you ultimately achieve both follow a parallel rationale. If the futures price is higher than the spot price (the current price) that signifies that the market is anticipating that the price will rise between now and the end of the futures contract. If the price rises more than that amount, then you earn a profit. If the price underperforms expectations, then you underperform cash. This is exactly the same dynamic as for Treasuries and stocks, real estate, and any other asset class. It all depends on how the future transpires relative to discounted conditions.

Another simple example involves inverted curves. If the futures curve is inverted that means that the futures price is lower than the spot price. This reflects a market expectation that the price in the future will fall. This may be the case if there is excess supply of the commodity, anticipated economic weakness, or for many other potential reasons. Regardless, if the price falls less than expected you will earn a positive return. For instance, if today's oil price is $100 and the 3-month futures price is $98, even if oil prices fall to $99 you still earn $1.

This is the same thought process that is used to analyze an inverted yield curve for bonds. There are times when a 5-year Treasury may offer a yield that is less than that of a 3-month Treasury. You might reasonably ask why investors would want to tie up their money for five years and be compensated with a lower yield than they can get by locking in their cash for only three months. Going back to the core principles applied above, an inverted yield curve—just like an inverted commodities futures curve—indicates a market expectation that interest rates are going to decline over time. This often occurs because of an expectation of an economic downturn that would cause the Fed to lower interest rates. (You may have heard of the familiar connection between inverted yield curves and recessions: Every time that there's been an inverted yield curve, an economic recession has occurred.) If interest rates actually fall more than is priced in, you would be better off locking in a lower rate for a longer period because you would earn more interest in total (even though your starting interest rate may be lower). In other words, the interest rate for a 3-month Treasury is temporary and when your bond matures you would reinvest your principle in a lower-yielding Treasury. After adding up all the reinvestments over a five-year period, you would have been better off locking in the lower five-year rate in the beginning. Conversely, if rates fall less than is priced in you would outperform with the shorter-term bond. It simply comes down to how the future plays out as compared to what was priced to occur. As a result, the concern that the spot price may be different from the futures price becomes a nonissue.

Economic Bias: Rising Inflation

Commodities are biased to outperform their average returns during periods dominated by rising inflation. This bias is reasonable and reliable. In fact, commodities are actually part of the inflation calculation. Rising prices in commodities such as energy, metals, and food directly and indirectly lead to broader increases in inflation measurements. The direct impacts on inflation measurements come from the fact that the methodology used to calculate the CPI incorporates changes in the prices of commodities. Meanwhile, indirect effects of rising commodity prices find their way into inflation of other items in the CPI basket because of the fact that these commodities are inputs into the prices of these items. For instance, higher gas prices lead to higher prices for traveling or shipping items because of the increased costs to those companies providing these services. At least a portion of the higher input expenses are typically passed on to consumers via higher prices, which results in higher overall prices for goods and services.

The fact that commodities represent a portion of the input cost of goods and services is another reason there is an inflation link in their returns. As general increased demand for goods and services pushes overall inflation rates higher, the higher demand for the goods and services leads to greater demand for the inputs (the commodities). The higher demand in turn exerts upward pressure on commodity prices. If the demand was greater than expected, then the price generally rises, because the demand originally expected was compared to the original supply to determine the price. This discounted future price is then reflected in the futures curve. Again, your profit depends on whether the future price comes in higher or lower than that price. This outcome will be based on how the future transpires relative to expectations, just as is the case with the other asset classes.

Economic Bias: Rising Growth

Commodities are not only pro-inflation assets, but also are biased to outperform during rising growth environments. As the economy outperforms to the upside, greater commodity demand naturally follows. If I earn more money than I had anticipated, then I am likely to spend a portion of that higher income. Part of that spending will either be directly on commodities (perhaps higher quality food, oil or precious metals) or on other goods and services that will require more commodities to produce. Because economic growth is greater than expected, it is reasonable that the original supply of commodities is insufficient to meet the higher, unexpected demand. This mismatch generally results in upward price pressures. It comes down to expectations versus actual results. Imagine if there was great optimism about the future prospects of the economy: We are living in a boom period and this prosperity is expected to continue. This view would likely result in higher futures prices for commodities, as well as an uptick in the production of commodities. If you are a commodities producer and feel that the economy is trending positively and commodities prices are rising, you will have the incentive to produce more commodities to meet the anticipated growing demand. Such lofty expectations are often not met since the margin of safety has shrunk. Even if the economy performs well, it would have to do better than expected in order to positively impact commodities prices (or stock prices, or the price of any pro-growth asset class). In the case of commodities, changes in both supply and demand lead to price changes and both are directly impacted by expectations of future economic conditions.

Putting It Together: Rising Inflation and Rising Growth

The historical average excess return of a diversified basket of commodities since 1927 is 2 percent per year and the average volatility has been a very high 17 percent, which is slightly less than the volatility of equities. Most importantly, however, during rising inflation periods (favorable times for commodities) the average excess return has been 8.4 percent per year. This represents the second-best asset class return (behind long-term TIPS at 10.7 percent) of the four major asset classes. Since rising inflation periods occur about half the time (relative to expectations), the benefits of owning this asset class should be apparent. The same analysis holds for the other economic environment in which commodities are biased to outperform: rising growth. Commodities have averaged a 7 percent excess return above cash when there is rising growth, which ranks second to equities. The average return of commodities during different economic environments is presented in Table 7.2.

Using rolling 10-year returns, as displayed in Figure 7.1, commodities have outperformed and underperformed as you would expect, given their economic bias.

The Advantage of the High Volatility of Commodities

Seen from a conventional viewpoint, the high volatility of commodities appears to be a negative attribute. However, when considering how commodities fit within the framework of a balanced portfolio, something remarkable occurs. You will discover that commodities are actually more valuable to the balanced portfolio because they are highly volatile. If they were not volatile, they would provide less of a benefit. This may sound like an exaggeration, but the following example provides support for this highly counterintuitive statement.

To prove this point, I will take an extreme example. Imagine if there were another asset class that offered exactly the same return as commodities but with zero risk or volatility. In other words, this asset class, which I will call no-risk commodities, has returned the same long-term percentage return as regular commodities (2 percent excess returns since 1927) but was able to achieve these results through a perfectly smooth return path. Commodities averaged a 2 percent return per year but had years when they were up by 60 percent and periods during which they were down by 50 percent. On the other hand, the hypothetical no-risk commodities earned 2 percent excess returns by earning 0.17 percent per month every month (which is 2 percent divided by 12) without exception. On its own this looks like a very attractive asset class and would score off the charts using traditional risk-return metrics. You are guaranteed to beat cash by 2 percent every year. You would think that this asset class is far superior to normal commodities.

As it turns out, the opposite is true. To demonstrate this I will compare the long-term average historical return of a balanced portfolio with regular commodities with the same balanced portfolio with our hypothetical no-risk commodities. For the balanced portfolio I have used the allocation that is presented in the final chapters of this book. At this point the makeup of this portfolio is not important. This comparison is presented here to demonstrate the significance of the volatility characteristic of commodities. You just need to know that the percentage of commodities in the two portfolios we are comparing is identical and the only difference is the substitution of the commodities return stream. One portfolio uses regular commodities and the other substitutes no-risk commodities. The goal is to completely isolate the impact of volatility on total portfolio returns.

The balanced portfolio's results are actually worse with no-risk commodities than with regular commodities. In this case, higher volatility is better than lower volatility! The comparison is highlighted in Table 7.3.

Does this result make sense from a conceptual standpoint when looking through the balanced portfolio lens? Of course it does. Regardless of the results, my objective is to ensure that you now understand why this result is actually more sensible. As I've covered previously, it is the concepts that stand the test of time as the environment will undoubtedly change in the future and new investment strategies and structures will be introduced. You can take these concepts and apply them to various economic environments and asset classes. The reason this outcome makes sense is because the strong returns arrive when you need them to balance underperformance in other parts of the portfolio. By producing a more stable return stream and by minimizing the losses during the really bad times, the improved overall balance that comes from owning commodities outweighs their individual unappealing return-risk characteristics. In this sense, commodities are the true team player!