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I occasionally am asked about what investment alternatives are available that may provide some inflation protection.

As I have discussed previously, there is no good alternative to TIPS if you want a low-volatility investment in real space. Since TIPS are explicitly indexed, buying a TIPS bond with a duration equal to your decision horizon is a zero-volatility investment (or essentially zero volatility) in inflation-adjusted terms. They are even less-volatile than T bills, in those terms.

The chart below is from an article I wrote several years ago with Bob Greer of PIMCO, called “History of Commodities as the Original Real Return Asset Class” and available in the book Inflation Risks and Products, by Incisive Media (2008). The method of analysis, though, is from Rob Arnott, the brilliant Chairman of Research Affiliates, and first appeared I think in the Financial Analysts Journal.

The usual connection between “risk” and “reward” is done in nominal, not real space; this chart puts the returns relative to the performance of an inflation-linked annuity – which would be the minimum possible risk. Notice the position of TIPS.

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Investment returns and risks, through 2006 only, in terms of real purchasing power

But there are several reasons to look at other inflation-sensitive investments. One is for diversification reasons. I am sure I am not alone when I say I am not completely comfortable in putting all my eggs in one basket, even if that basket is held by the world’s only military superpower. Another reason, particularly poignant these days, is for incremental performance. With TIPS’ real yield negative out to 2017 (see Chart below, Source: Enduring Investments), other riskier alternatives start to make real sense.

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Yipe! Lots of negative real yields here!

Commodity indices are (as Bob and I discussed in that chapter) neat inflation-resistant investments because they not only have exposure to real stuff, but also a source of real return over time. This is not true of direct investment in commodities: unless your investment is making, mining, or growing more stuff, you’re going to end up with the same pile of stuff and definitionally a zero real return.

There are a number of ways to invest in commodity indices, but I found an interesting one today (disclosure: I bought some of this ETF but receive no compensation of any kind for discussing it). The symbol for the United States Commodity Index Fund is USCI. It has $34mm under management and is only two months old.

USCI has an expense ratio of 0.95%, which isn’t egregious for a commodity fund. It has two significant items in its favor. One is its design, which I’ll get to in a minute; the other is its pedigree. The fund is managed by SummerHaven, which is a company co-founded by Yale University Professor Geert Rouwenhorst and advised by Gary Gorton. These two guys wrote a terrific paper back in 2005 called Facts and Fantasies about Commodity Futures, which ought to be required reading if you are investing in commodities. In this paper, they demonstrated that investing in an index of commodity futures, compared to investing in spot commodities, offered a far different (and better) source and distribution of returns. For example, they showed that a buy-and-hold strategy in spot commodities would have earned a compounded return from 1959-2004 of 3.47%, compared to 4.13% compounded inflation (and this ignores storage, insurance, and other carry costs). However, investing in commodities via collateralized futures contracts would have earned 10.31% compounded. The chart below makes that point visually, and is from that paper.

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Commodity futures have crushed spot commodity returns.

So, these guys know a little bit about commodities.

Their knowledge of the drivers of commodity returns lends itself to the design of a credible commodity index product. The USCI takes advantage of the observation that in the return of a commodity futures strategy, it matters quite a bit whether the futures curve is in “backwardation” (meaning that forward months trade at a lower price than the spot month) or “contango” (which means that the forward months trade at a higher price). In a contango market, when the investor who is long the spot contract needs to roll to the next contract, he is selling the lower-priced contract and buying the higher-priced contract. This is the reason that USO (which owns front-month Crude Oil contracts and rolls monthly) has underperformed spot crude oil dramatically since inception (spot oil up 16%, USO -49% since 4/10/06).

A normal commodity index owns a broad group of commodities. It owns the ones in contango and the ones in backwardation. But USCI only owns 14 of the 27 eligible commodities at any one time. It selects the commodities it is invested in, monthly, based on a number of factors of which the degree of contango or backwardation is an important one. An index created using the rules USCI uses outperformed the S&P GSCI over the last five years by 255% (see Chart below). Yes, that’s right, 255%. Of course, that doesn’t include expenses, so subtract 5%. And there are other slippages to an actual product compared to the index. But 50% per year outperformance will cover a lot of sins.

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Selectively choosing the 14 "best" commodity futures seems to be a good idea

The chart here is instructive for another reason – the massive draw downs that occasionally happen are not fun, and even with a good commodity index, you still have significant volatility. When people ask me “how much of my portfolio should be in commodities,” my answer is “it depends entirely on your risk budget. Your investment will be constrained by the risk you are willing to take. I suggest thinking about the class of commodity investments the way you would think about a single stock. How much of your portfolio are you willing to risk on a single stock? The answer to the question about the limits of a commodity investment will be of the same order of magnitude. If you are willing to risk no more than 3% of your portfolio on a single stock, I might say that 5% is a reasonable concentration in commodities. If you typically risk as much as 10% of your portfolio on one idea, then 10-15% in commodities is an amount of risk you may be comfortable with. If you’re risking more of your portfolio than that on one concept…then you may want to reconsider your risk! (Of course, these are only guidelines – your situation is unique and ought to be addressed as such).

Disclosure: Long USCI.

Source: Better Than TIPS: For Inflation Protection, Consider This Commodities ETF