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I really liked this piece by Ben Carlson on commodities and how they might fit into your portfolio (I like Ben’s piece primarily because he agrees with my views so you’ve been warned in advance!). He goes over the historical performance of commodities and concludes that commodities are best used as trading vehicles and not something that you should invest in. As I’ve discussed in the past on several occasions I completely agree (see here and here). My thinking is a little different from Ben’s though.

Commodities are substantial cost inputs in the capital structure. So they don’t tend to produce real long-term returns due to their high correlation with the rate of inflation. And the trading of commodities has traditionally been done not for the purpose of generating a profit, but hedging a business activity. For instance, a classic example of commodities trading is an airline that hedges fuel prices in order to make their business forecast more stable. They aren’t really trying to generate a profit. They are trying to lock in a price so their business can be run more efficiently. The commodity is being used more like insurance than a profit making vehicle.

The evolution of commodities as a vehicle for pure profit is a much more recent thing that seems to have arisen with Wall Street’s increasing promotion of these vehicles as an extra asset class that you can “diversify” through. I don’t like that one bit. I think it stinks of Wall Street trying to repackage an asset class as something it’s not just so it can push it on unwitting investors. Hence the rise of countless commodity ETFs and trading strategies designed around “diversifying” into “alternative asset classes”.

In my opinion, a portfolio should be constructed primarily around instruments that are tied to the underlying production of the economy. It’s fine to use commodities as a hedging vehicle in some cases, but I think it’s crucial to understand where commodities sit in the capital structure, why their long-term returns have been very poor and why commodities aren’t a sound long-term bet as a core portfolio holding.

Anyhow, I’ll get off my soapbox. Go have a read of Ben’s piece.

Source: Thoughts On Commodities As An Asset Class