A Fresh Look At Commodities

 |  Includes: DBC, GCC, GNR, GUNR
by: Morningstar

By Alex Bryan

Investing in commodities can be a little intimidating. They are frequently touted for their attractive long-term returns, diversification benefits, and as a hedge against both inflation and a decline in the value of the dollar. But in light of commodities' poor recent performance, and seemingly high correlation with stocks, it is worth re-evaluating each of these arguments in turn.

It can be difficult to understand how a piece of metal or stash of corn can offer investors a real return over the long run. After all, the immediate needs of producers and consumers determine commodity spot prices, rather than investors' return requirements. However, several researchers have argued that commodity futures contracts historically have compensated investors for offering price insurance to commodity producers (see Facts and Fantasies about Commodity Futures).

A futures contract is a standard exchange-traded agreement between two parties outlining the price and terms at which a future asset sale will take place. These contracts allow investors to gain exposure to commodities without holding the physical goods, which can be prohibitively expensive. Because no cash changes hands at the initiation of a futures contract, investors can place the notional principal in short-term T-bills, which can further enhance returns.

Commodity futures are not perfectly correlated with the underlying spot prices. In order to avoid taking physical ownership of the physical goods, an investor needs to sell each contract prior to expiration and replace it with one maturing further out. The new contract may have a higher price than the spot price on the date of the switch (this is called contango), which may cause the investor's performance to lag the spot commodity. This may happen if the costs of storing the commodity are high or if the market expects spot prices to increase over the life of the new contract.

The chart below illustrates the performance of three versions of the Dow Jones-UBS Commodity Index. The spot index approximates trends in commodity spot prices, ignoring storage costs, while the excess return index tracks the performance of the futures contracts after taking into account the net costs or benefits of rolling over the contracts (contango/backwardation). The total return version equals the excess return index plus any interest earned on short-term T-bills, assuming the contracts are fully collateralized. It offers the closest approximation of what a commodity futures investor could earn gross of fees.

Click to enlarge
Source: Morningstar.

From December 1990 through May 2013, the spot index gained 6.6% annualized. Of course, this is not an investable return. Storage costs and expected appreciation of spot prices eroded returns on the excess return index to 1.2% annualized, which is less than the pace of inflation. However, the total return index posted a 4.4% annualized return. In other words, most of the return on an investment in commodities futures contracts came from interest on T-bills, rather than from capital appreciation on the underlying contracts. This is hardly compelling compensation to justify equitylike risk.

However, these results are sensitive to the commodities included in the index and the weighting approach. The Dow Jones-UBS Commodity Index uses a combination of liquidity and production data to weight each commodity contract. I constructed an equally weighted total return index, representing a broad basket of energy, agricultural, and metals commodities, which returned 11.7% over the same period as described above. Equal-weighting is an active contrarian strategy that may enhance returns over the long term. Incidentally, GreenHaven Continuous Commodity Index (NYSEARCA:GCC) (0.85% expense ratio) offers such a strategy.

Commodity futures have exhibited very low (and sometimes even negative) correlation with stocks and bonds. This is because commodity futures and stocks performed well over different parts of the business cycle. The stock market tends to be forward looking and historically has done the best during late recessions and early expansions. In contrast, demand for commodities historically has lagged the business cycle. Consequently, commodity futures have performed the best during late expansions and early recessions. What better way to diversify a portfolio than with two potentially high-returning asset classes that perform well over different times, or so the argument went.

However, correlations between commodity futures and stocks have spiked in recent years, particularly in the wake of the 2008 financial crisis. Over the trailing 10 years through May 2013, the Dow Jones-UBS Commodity Index and the S&P 500 Index were 0.51 correlated. That's greater than the correlation between stocks and investment-grade corporate bonds during that span (0.30). The chart below illustrates how correlations between stocks and commodity futures have changed over the past two decades.

Click to enlarge
Source: Morningstar.

There a couple of possible explanations for the recent rise in correlations. When credit dries up--such as during the 2008 financial crisis, European sovereign debt crisis, or other major credit event--it is bad for both the real economy and global stock market. The risk of these events, and similar macroeconomic shocks, may be higher today than in the past. Some commentators also have suggested that the increase in investor interest in commodities has driven correlations higher. But whatever the cause, it is reasonable to expect that correlations will be higher going forward than they were historically. Of course, that doesn't mean commodities have lost their diversification appeal. They still can offer better diversification benefits than international stocks, and as the global economy strengthens, correlations may start to recede.

Inflation Protection
It is true that commodity futures offer a reasonable (though not perfect) hedge against inflation. However, some of this protection comes from the interest earned on the collateralized investment in short-term T-bills. These securities historically have offered pretty good inflation protection because they are priced to reflect the market's inflation expectations over short horizons. From December 1991 through May 2013, rolling annual returns on the Dow Jones-UBS Commodity Index were 0.63 correlated with annual changes in the Consumer Price Index (CPI). The corresponding figure for the S&P 500 Index was only 0.14. While stocks historically have been uncorrelated with inflation over the short term, they have fared better than bonds, which tend to be negatively correlated with inflation.

Unlike stocks and bonds, commodity prices are directly linked to components of the CPI, including food and energy prices. However, commodities do not offer an effective hedge against other parts of the CPI, such as health care, tuition, and rent. Treasury Inflation-Protected Securities (TIPS) offer a more direct way to hedge against an unexpected erosion of purchasing power.

The Dollar
A strengthening U.S. dollar can wreak havoc with commodity investors' portfolios. This is because commodities are priced in U.S. dollars, but most are primarily produced overseas. When the dollar strengthens, it takes fewer dollars to purchase those commodities from foreign producers, which causes spot prices to fall. The opposite is true when the dollar weakens. This inverse relationship can make commodities a good hedge against a decline in the value of the dollar. But this hedge is no more effective than holding a broad basket of foreign stocks. For instance, from 1996 through May 2013, the returns on the Dow Jones-UBS Commodity Index were negative 0.50 correlated with the Broad Trade Weighted U.S. Dollar Index. During that span, the MSCI World ex USA Index exhibited slightly lower correlation with the U.S. dollar (negative 0.62).

Investment Options
PowerShares DB Commodity Index Tracking (NYSEARCA:DBC) (0.85% expense ratio) and GreenHaven Continuous Commodity Index GCC are two of the better broad commodity futures exchange-traded funds. DBC and GCC select the contract expiring within the next 13 and 6 months, respectively, that minimizes contango. DBC skews its portfolio toward energy and agricultural commodities, while GCC employs equal weights to each commodity, which may make it a better option for investors seeking broad diversification.

By investing in the stocks of commodity producers, investors can avoid potential contango altogether. They are also cheaper to access. While these companies' fortunes are tied to the prices of the commodities they sell, this relationship is weaker than the relationship between futures and spot prices. That's because many of these firms hedge their commodity exposure in the short term. Many large producers also operate multiple business lines and have significant operating leverage, as well as, in some cases, political risk. Investors in these companies aren't just betting that commodity prices will rise, but also, that these firms will be able to keep costs in check. These stocks also tend to be more highly correlated with the broad equity market than commodity futures.

While many funds that focus on commodity producers skew toward the energy sector, SPDR S&P Global Natural Resources (NYSEARCA:GNR) (0.40% expense ratio) and FlexShares Morningstar Global Upstream Natural Resources ETF (NYSEARCA:GUNR) (0.48% expense ratio) offer more-balanced exposure. GNR assigns equal weights to the energy, agriculture, and metals and mining sectors, and applies market-cap weighting within each sector. GUNR takes a similar approach, but adds a few water and timber companies to the mix.

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