I published an article on January 15th titled Insight Into Commodity Investing, and I have received interest from individuals asking me my opinion on adding commodities to a portfolio. In this article I will go into further detail explaining the academic reason for investing in commodities and then provide you with my personal opinion/outlook on commodity investing both from an index investor's point of view and for those that want to actively invest in individual commodities. In writing this I am assuming readers have read my previous article and will not be expanding on those topics.
Before I start, I want to make clear that these are my opinions, specifically, my outlook and how to invest in commodities. Every investor has unique circumstances and should invest according to their risk and return objectives.
I will start with the academic reason for investing in commodities because it provides an educational perspective on why investors should include commodities into a portfolio. The numbers in this paragraph come from a study (source: CISDM (2005b)). This study is being used only for the purpose of demonstration. I am not implying it was the best study or the most accurate.
The study looked at the time period between 1990-2004. Portfolio one was split 50/50 into the S&P 500 and the Lehman Gov./Corp. Bond Index. Portfolio two had 40% in the S&P 500, 40% in the Lehman Gov/Corp. Bond Index, and 20% in the GSCI which is a long-only futures based commodity index. Annualized return was 9.64% for portfolio one and 9.51% for portfolio two with a standard deviation of 7.94% and 7.19% respectively.
The Sharpe Ratio was used to evaluate the two portfolios from a return/risk perspective and produces a result of 0.67 for portfolio one and 0.73 for portfolio two. These results suggest portfolio two is a dominate portfolio relative to portfolio one. Therefore, commodities should be added to a traditional stock and bond portfolio. This as well as other studies performed have persuaded many to add commodities to their portfolios. I agree with this perspective that investors of all ages should include commodities in their portfolios. However, I believe this allocation amount should vary given various circumstances. Currently, for index investors I believe, if you haven't already, that you should be increasing the allocation percentage in your portfolio to commodities. Three reasons for this are protection against unexpected inflation, supply/demand, and current Federal Reserve actions.
In that previous article, I provided insight into the misconception that commodities hedge against inflation. Again, this is incorrect. They hedge against unexpected inflation. I predict that between now and ten years we will have unexpected inflation and specific commodities will perform best in this scenario (again, for specifics on which commodities please see my previous article). For my reasoning I use the eyeball test. Yes, I understand scientifically and academically this isn't the most sound way to invest. What I look at to predict unexpected inflation are current bond yields. Specifically I look at zero coupon treasury bonds. Bond yields are based on performance risk and inflation risk. I use zero coupon treasury bonds because performance risk is removed and we are left with inflation risk.
Also, zero coupon treasury bonds do not have reinvestment risk unlike traditional treasury bonds. As of today (source: TDAmeritrade) zero coupon treasury bonds maturing on 5/15/2020 are yielding 1.157% and bonds maturing on 11/15/2022 are yielding 1.642%. Using the eyeball test, this suggest that expected inflation over seven years is expected to be 1.157% and over ten years 1.642%. Again, I know this isn't the best way to estimate unexpected inflation but I'm not trying to get an exact number. Rather, I am attempting to make this a binary event meaning either there will be or won't be unexpected inflation. I personally believe inflation will be higher than what is currently being anticipated, specifically more than the 1.157% implied by the seven year bonds therefore leading to unexpected inflation in which commodities will have positive returns.
In my previous article, I state one of the main drivers of returns for commodities is supply and demand. Over the years, one reason given for investing in commodities is that global market demand will continue to grow and supplies are limited, therefore price must go up. I believe that this relationship will hold true especially over the coming years because I believe we will experience a pick up in global growth which we have already began to see.
My last reason for increasing allocation to commodities is based on actions taken by the Federal Reserve. I spoke of the academic reasons for investing in commodities earlier in this article. Further studies have demonstrated that these benefits are almost exclusive to when the Federal Reserve is pursuing a restrictive monetary policy. I believe this happens because the Fed pursues restrictive monetary policy when inflation is above their targeted level meaning there is unexpected inflation. I anticipate the Fed will pursue a more restrictive policy (relative to current policy) sometime over the next ten years. (as a side note, I'm well aware of the Fed's dual mandate regarding employment goals as well as inflation goals)
RECOMMENDATION FOR INDEX INVESTORS
As I stated before, I believe index investors that actively change allocations should have an overweight position in commodities relative to their "normal" allocation. I believe investors should concentrate on indices that have a high concentration in energy commodities and also have exposure to metals. I also believe investors should add individual positions of commodities that may not be included in the index because of the increased correlation among indexed commodities. For example, the ETF Powershares DB Commodity Index Tracking (NYSEARCA:DBC) does not have platinum featured in the index. Platinum can be added to the portfolio through futures contracts or ETF's (PALL invests in Palladium and PPLT invests in platinum). For an explanation of my reasoning please see my previous article.
As for investors that wish to seek alpha by investing in individual commodities, I will discuss how I personally invest in them and provide a few examples. I personally try to make it as simple as possible and invest based on various scenarios.
My first ever play in commodities was gold back in 2004. This was based on the outlook that the Fed would implement more restrictive monetary policies which they did in the preceding years and global increase in demand. In 2009 oil had an average price roughly around $53. When it was in the $40 range I went long simply on the belief that in the long run it would increase back into the $80 range again based on global demand. In June of 2012 I went long natural gas and gave a recommendation to go long platinum. Natural gas at that time was at all time lows. During the summer months much was written in regards to the platinum mines in South Africa (issues that still persist). These mines control much of the platinum supply so the thought was lower supply and increased global demand will increase the price. As of yesterday platinum surpassed the price of gold for the first time in 10 months. These are examples of circumstances that I personally look for. I have been asked about my opinion of Corn. One play would be to go long based on the increased ethanol use in the United States. However, Corn has soared in price much of which is attributed to the drought. I am currently staying away from corn because I think it's foolish to try and predict weather and if the drought is going to end or not.
I want to reiterate one important point in this article. These are my personal opinions and I understand that everyone will not agree with them. As always, I recommend that each investor develop their personal investment thesis based on their personal objectives.
Disclosure: I am long UNG. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.