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Diversifying With Commodities? Watch How They Roll


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Up to a Point, Lord Copper

Times like these call for commodities. That’s what common sense dictates, and it’s one of those rare occasions when experience and theory agree; in times of inflation, commodities are a better bet than either stocks or bonds. The latter stand to be damaged by inflation, while the former actively contribute to it. And indeed, commodities have had a great time of it since the inflation scare began to take hold early last year.

But nothing’s guaranteed. Commodities across the board rallied after the Russian invasion of Ukraine, now three months ago. Energy commodities have continued to rally, according to the Blomberg commodity spot price indexes; the same is not true of industrial or precious metals, or of agricultural commodities:

All of these commodities are traded in large and liquid futures markets. If we turn to the Commodity Research Bureau’s RIND (Raw Industrials) index, which covers the more important commodities that aren’t traded on futures and so arguably respond more directly to supply and demand pressures in the real world rather than in the index, a consistent rise to an all-time high has been followed in the last few weeks by the biggest correction in a while. It’s now approaching its 200-day moving average: 

So there’s the eternal risk that it’s too late to dive in, which is compounded at present by the exceptionally high levels of geopolitical uncertainty surrounding Russia and also the Covid-driven shutdowns in China. 

Then there is the issue of how best to invest in commodities, and how to combine them with other elements of a portfolio. One of this century’s most famous and influential academic papers in financial theory was 2004’s Facts and Fantasies About Commodity Futures, by Gary Gorton and Geert Rouwenhorst of Yale School Of Management. They updated it a decade later. It found that investing in commodities on a long-only buy-and-hold basis, in a way that financial instruments were then making possible, offered the virtual holy grail of asset allocation. Add commodities to a portfolio of stocks and bonds and they would act as a diversifier, adding to return while also reducing risk in the form of volatility.

That sparked a massive influx into commodities in the years ahead of the Global Financial Crisis. And it was based on accurate information. AQR, the fund management group, published its own research on commodities this week. The long-term historical data brooks no argument:

Over time, commodities have a very mild positive correlation to stocks, and a very mild negative correlation with bonds. They plainly do provide diversification. Over the full period, AQR shows that in periods of “inflation surprises,” when inflation was shocking investors more than growth, bonds and stocks are positively correlated (meaning that they tend to go down together), while commodities are negatively correlated with both. 

So, adding some commodities to a standard 60% stocks/40% bonds portfolio does indeed improve risk-adjusted returns. Here is AQR’s math:

The problem is what happens in practice. Back in the mid-aughts, people piled into commodities, and also into emerging market assets (largely dependent on commodities). As the problems for credit in the US and western Europe grew ever clearer, it became a popular trade to bet against western banks and put the money into commodities, particularly oil. The problem was that at a certain point the trade was bound to collapse under its own logic. If the western financial system was going to collapse, then that would have a terrible effect on the demand for oil. That led to one of the most spectacular reversals in history in July of 2008, two months before the collapse of Lehman Brothers. What follows may be my personal favorite illustration of the utter insanity that took over that year. It shows the performance of West Texas Intermediate oil futures, relative to the KBW index of US banks. Extraordinarily, by year-end bank shares had held their value better than a barrel of oil. In the interim, lots and lots of money was made and (mostly) lost:

Various lessons emerge from this for the present. One is that commodities don’t exist in a vacuum. Another is that there is more to diversification than spreading across asset classes, or even geographies. Before the crisis, it was popular to pile into commods, emerging markets, and carry-trade currencies. All fell together, because the same people were invested in all of them and needed to sell at the same time. All they had done was make the same bet with many different bookies. 

There are also limitations to the notion of “buy and hold” when applied to commodities. Buying a stock and holding it is one thing. It grows and pays dividends that can be reinvested. Buying a barrel of oil and storing it away is something quite different. To quote Vincent Deluard of StoneX Group Inc., it’s “abnormal” for commodities to make up a significant part of an optimal asset allocation portfolio, because: 

Only income-producing assets can generate sustainable returns, and real commodity prices tend to drop over time as human ingenuity figures out new ways to produce more with less.

Another problem concerns the mechanics of maintaining a “long” exposure to commodity futures. Over time, a futures contract will expire and will need to be rolled over into the next. If that contract was selling for more than the current price of the next contract (backwardation in the commodities trading lingo), then you make money each time you do it. More usually, it is in contango, and the need to roll over the contract loses you money. Over time, this matters a lot. This chart compares the Bloomberg Energy spot index (showing the price that oil trades at in the market) against the Bloomberg Energy index, which captures the return from continuously investing in futures and rolling them over. For much of the last decade, roll yield lost a lot of money:

It’s probably not a coincidence that the futures and spot prices only started to diverge in a big way once large numbers of investors began to try using them as diversifiers in 2005. Diversifying into commodities needs to be done carefully, and can be counterproductive. It shouldn’t be thought of as a “passive” investment on a par with an S&P index fund. 

How to proceed, then? AQR suggests a number of systematic tweaks to a purely passive approach of buying, holding and rolling over futures contracts. Yes, this will involve higher fees, but there is more justification for this in commodities than in stocks or bonds because the transaction costs really can be expensive. All the factors that drive equity performance are also present in only a slightly different form in commodities: 

This is complicated stuff, and you don’t want to overpay for it, but it makes sense. If you’re convinced that we are in an inflationary regime for a while (and I think you probably should be), then you need to find a way to expose to commodities, without making the ghastly mistakes that contributed to the disaster of the summer of 2008.

Other ways to gain exposure without necessarily paying so much for the privilege: commodity-backed currencies, such as the Brazilian real or Canadian dollar, and the stocks of energy and mining companies. In the latter case, years of underperformance help the cause, and you’d at least have the advantage of being paid some dividends, which isn’t going to happen from investing in oil futures.

There are political risks as the oil majors suddenly enjoy a great time. The UK imposed a 25% windfall tax on oil companies’ profits Thursday. If a nominally Conservative government like Britain’s can do this, it’s wise to expect others will follow. However, as shares in both BP Plc and Shell Plc, the two British oil majors, rose for the day, it doesn’t look for now as though the risk is too deadly. 

One final concern echoes 2008. If commodity prices in general, and oil prices in particular, keep doing what they’re doing, that can be expected to have ugly effects on the economy and on society. It appears that there is another “risk-on” rally in force at present, as stocks rise and bond yields look as though they may have peaked for now. But oil is still hitting new heights:

Meanwhile, prices at the pump, in an age of increasing anxiety, have also risen to a new high. That threatens social discord if it continues. It also risks collapsing under its own weight as demand is destroyed (although American demand for gasoline is robust). Prices at service stations could not be more visible, displayed in large numbers on roadside signs as people drive by. This cannot be healthy:

Until now, energy stocks have offered a way to make money in a very risky climate. Indeed, it would also have been wonderful protection against the recent problems for the FANG stocks. Given the extent of previous underperformance, there’s conceivably room for them to go further:

Even with that kind of a rally behind them, energy and materials stocks look like wise holdings for an inflationary environment. But it’s necessary to proceed with care.

Please indulge me. I know people don’t subscribe to this newsletter for my political opinions, but I’m finding it impossible to tolerate the refusal of American politicians even to engage with possible changes to the law that might prevent massacres like the one in Uvalde, Texas. It’s a complicated issue, and the US Constitution deserves the utmost respect as arguably the key reason why the country has enjoyed such exceptional success. But it doesn’t stop people of good will from resolving problems of which the Founding Fathers could scarcely have conceived. And there’s no other country where the issue of regulating guns is even thought of as particularly political. 

The claim at present is that even to raise the issue of extra controls on guns following a massacre is to “politicize” it. So I suggest reading this retrospective on the 1996 Dunblane massacre, in which a man murdered 16 children and their teacher in a school gym in Scotland and then shot himself. The young Andy Murray, a future Wimbledon champion, was in the next room. I had to cover the story and the political response to it, and the difference with what is occurring now in the US is painful to behold.

By strange coincidence Michael Forsyth, then the Scottish Secretary and a Conservative, was the MP for the constituency that included Dunblane, while the Labour “Shadow” Scottish Secretary, George Robertson, lived locally and sent his children to the school. Both were deeply affected, and even though they were direct opponents, they held a joint press conference at the end of the day. Neither attempted to score any points on the other. Forsyth promised to look to see if there were any changes to the law that might prevent a recurrence of such a tragedy, and Robertson promised to back any sensible reforms that resulted.

The first part of the new gun control legislation was passed under John Major’s Conservative government, and banned all cartridge ammunition handguns with the exception of .22 caliber single-shot weapons. Tony Blair’s Labour Party won the 1997 general election and seamlessly passed a second act that banned the remaining .22 single-shot handguns, too. There hasn’t been a mass school shooting in the UK since. And as governments have been voted in and out several times since then, and Britons even successfully defied the political establishment to leave the European Union, there’s no sign as yet that tyranny has resulted.

The British reforms would not be allowed under the 2nd Amendment to the US constitution that says that the right to own and bear arms “shall not be infringed.” That wording deserves respect, and there is no way that it’s going to be amended or repealed. But other options are open. Both the Uvalde atrocity and the recent mass shooting in Buffalo, New York, were perpetrated by 18-year-olds. Would the Supreme Court really hold that raising the age for gun ownership to 21 would “infringe” the right to bear arms? With few exceptions, the law doesn’t allow people to buy or drink alcohol until that age, after all. Does the considerable effort and red tape needed to earn a driving license and then buy a car really “infringe” on our ability to own and operate a motor vehicle (not a constitutionally protected right, but even more central to American life than gun ownership)? I don’t see that it does, and the Supreme Court needn’t do so, either. Well-drafted legislation subjecting guns to the same sensible regulation (and the word “well-regulated” does appear in the 2nd Amendment) would almost certainly have thwarted these last two massacres and many before them.

Finally, while the 2nd Amendment is politically immutable, the judicial understanding of it isn’t. As anyone who’s been monitoring the abortion debate should know, interpretation of the Constitution can change over time.

It’s simply bad faith to say that it’s “political” to explore these possibilities, or to claim that the Constitution prevents any discussion. Such an attitude doesn’t deserve respect. The rest of the world looks on in horror. I wasn’t born in the US but I’ve chosen to live here, and my children, all US citizens, deserve the rights to “life, liberty and the pursuit of happiness” that Thomas Jefferson wrote into the Declaration of Independence. Refusal by politicians even to consider measures to make them safer at school infringes those rights. That’s contemptible.I promise not to make a habit of this, but it matters much more than the topics I normally write about.

First of all, an apology. Earlier this week, when I wrote up a report on investing under inflation by the Man Group, I managed to rename Campbell R. Harvey, one of the authors, as Cameron Harvey, and to leave out all mention of another author, Ben Funnell. I have an often-misspelled name myself, and I have no excuse. Sorry.

Lightening the tone, a lengthy discussion of commodity futures leads naturally to one of the greatest and funniest movies ever made, “Trading Places.” The film, released in 1983 and starring the then very youthful “Saturday Night Live” alumni Dan Aykroyd and Eddie Murphy, is about as close to objective perfection as a film can be. In the closing scenes, our heroes thwart the dastardly Duke brothers by cornering the market for frozen concentrated orange juice. It’s worth watching and if you’ve never seen the whole film, then you really should. I don’t know how many times I have, and it never ceases to make me laugh. Have a good weekend everyone. 

More From Other Writers at Bloomberg Opinion:

• Dysfunctional Republicans Bail Out on Guns: Jonathan Bernstein

• The Gun Debate Needs to Break Old Patterns: Ramesh Ponnuru

• Why We Don’t Know How to Stop School Shootings: Julianna Goldman

This column does not necessarily reflect the opinion of the editorial board or Bloomberg LP and its owners.

John Authers is a senior editor for markets and Bloomberg Opinion columnist. A former chief markets commentator and editor of the Lex column at the Financial Times, he is author of “The Fearful Rise of Markets.”

More stories like this are available on bloomberg.com/opinion

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