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Worth Considering: Evaluating the investment case for commodities

David Peartree

David Peartree

Are commodities an asset class worth owning?

Unlike stocks and bonds where the discussion focuses not on whether to own but mainly on how much of each should be held, the case for including commodities is less clear-cut. A case can be made, but the argument is not conclusive.

Two primary considerations for owning any asset class are: 1) do they provide good long-term returns and 2) do they have a low correlation with other major asset classes, particularly stocks. A third consideration offered in favor of commodities is their supposed ability to hedge against inflation.

The first thing to understand is the distinction between commodities and commodity futures. Most investors gain access to commodities not by investing in physical commodities but by investing in commodity futures, a type of derivative. A futures contract is an agreement to buy or sell a specified amount of a given commodity at a fixed price on a future date.

Commodity futures as an investment have a relatively short history. Historical data for the Dow Jones-UBS Commodity Index only dates back to 1991. Academic studies trying to analyze the long-term returns of commodity futures have been forced to construct hypothetical indexes of equally weighted portfolios of various commodities. Even then, the best data only goes back to about 1960.

A study by Vanguard estimated average annual returns of 9.8 percent for commodity futures for the period 1959 through 2009. Those returns are impressive and even slightly better than the average annual returns for U.S. equities over the same period. The caveat is that the Vanguard study was based on a hypothetical index of 21 equally weighted commodities and doesn’t reflect the actual experience of any investor.

The long-term returns for physical commodities are less impressive. A study by Société Générale, the French multinational bank and financial services company, finds that the long-term real returns of physical commodities over the past 130 years have been essentially flat. Adjusted for inflation, the price of commodities is essentially unchanged. How can that be? Human ingenuity. Over time innovation has lowered the cost of extracting or producing various commodities.

Commodity prices can swing dramatically over shorter periods, however, creating opportunities for traders and speculators and the impression that long-term investors can make money too.

If commodities themselves offer no real long-term return, the case for commodities exposure rests on the assumption that commodity futures provide a reliable source of long-term returns that physical commodities do not. That may turn out to be the case, but at this relatively early point in the history of commodity futures as an investable asset, some caution and skepticism are appropriate. This is, after all, an asset class that pays no dividends or interest income. Investors can only make money if prices continue to rise.

What about the correlation of commodities futures with other asset classes, especially stocks? The purpose of adding additional asset classes to a portfolio is to enhance diversification by mixing asset classes that do not move in lock step. The low to negative correlation of stocks and investment grade bonds is a classic example. In portfolio theory, high correlations between asset classes are bad, low correlations are good, and negative correlations are even better.

Indeed, for many decades commodity returns have shown a low to negative correlation with stocks, averaging around zero since 1959. Since the financial crisis in 2008, however, the correlation with stocks has been more persistently positive.

As correlation is measured, 1 indicates a perfectly positive relationship, 0 indicates no relationship and -1 indicates a perfectly inverse relationship. Since 2008 the correlation of commodities and stocks has increased to as much as .8, significantly reducing the diversification benefits of commodities in a portfolio. Correlations have decreased a bit over the past year, but the trend of higher correlations is still intact.

The third portfolio justification for commodities is the hedge they are supposed to provide against inflation. To offer protection, commodities should have a strong, positive correlation with inflation. The results are mixed.

Over the past 50 years, commodities have offered better protection against inflation than stocks or bonds, but it has been limited. The correlation of stocks and bonds with inflation has been slightly negative. The correlation of commodities with inflation has been positive, but only slightly.

The investment case for commodities is not without merit but neither is it conclusive. The strongest argument for commodities is their historically low correlation with stocks. Even if that relationship reasserts itself, however, it will be of no lasting benefit to investors unless commodities can also deliver good long-term returns and there are reasons to question their ability to do so.

For many long-term investors, an appropriately balanced portfolio of stocks and bonds continues to be a sensible choice.

David Peartree, JD, CFP® is the principal of Worth Considering, Inc., a registered investment advisor offering fee-only investment and financial advice to individuals and families. Offices are located at 160 Linden Oaks, Rochester, NY 14625; email david@worthconsidering.com.

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