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By Joseph Hogue, CFA

This is the second of twenty articles written exploring the myths in popular investing as exposed in Michael Dever’s new book, “Jackass Investing.” In the book, Dever uses experience from three decades of hedge fund management to explore how the conventional wisdom in investing and portfolio management preaches little more than gambling. For an introduction to the series and the book, see our previous article looking at the return drivers for stocks.

Myth #11 in the book addresses the general fear among regular investors of commodities. Though this fear, or the myth that commodity investing is riskier than equities, has certainly declined over the last few years, trading in commodities by individual investors still lags equities considerably. Many investors have turned to exchange traded funds (ETFs) to add exposure to commodities while still believing direct investment in the futures market is too risky.

Are Commodities Too Risky?

Ever since Winthorpe and Billy Ray Valentine bankrupted the millionaire Duke Brothers with one day of trading in orange juice futures in the movie, “Trading Places,” I have held the same fear of commodities as most regular investors. It’s too volatile and will break you in a heartbeat. Despite Mortimer and Randolph’s experience, one only needs to look at standard deviation, the common measure of volatility, relative to equities to see this isn’t the case.

The author shows us in the chart below that between a cross-section of commonly held stocks and commodities, stocks have been the more volatile over the last decade. I was a little skeptical of the author’s choice of time period. The last decade, more precisely the years 2000 and 2008-2009, have seen uncharacteristic levels of volatility in equity prices. I was surprised after looking at the standard deviation for equities excluding these periods, measuring February 2001-January 2008, only reduced volatility marginally to 1.8% for Microsoft (NASDAQ:MSFT) and 1.7% for General Electric (NYSE:GE) but that they were still above that of commodities.

[Click to enlarge]

So, why do investors hold on to the notion that commodities are riskier than equities? We need only go back to our friends Mortimore and Randolph and their irresponsible use of leverage. The SEC limits the amount of leverage an investor can have in equities at 50% meaning a $10,000 investment requires $5,000 to be placed in an account. Recently the Chicago Mercantile Exchange (CME) raised its margin requirements on gold and silver futures.

The result, leverage for silver futures is at 8:1 and for gold futures, 20:1. So that same $5,000 you used to buy $10,000 worth of stock, could have bought $100,000 worth of gold! Sounds great, no? Not so fast. Have a bad day in the stock market and a 5% fall in equity values with 50% margin will cost you $500, or roughly ten percent of your invested funds.

That same day in the futures market and you will lose your entire investment of $5,000. These large losses, according to the book, “from the abuse of leverage are the primary reason that commodities appear riskier than stocks.” In reality, which seems riskier - buying the rights to a physical commodity that has tangible value or trading electronic credit for partial ownership in a business venture where management is far removed from ownership? Commodity futures, traded with a responsible use of leverage, are not riskier than equities. Investors limiting themselves from an entire asset class put themselves at a disadvantage to more informed investors.

The Risks in Commodity ETFs

Despite their own misinformed views, investors have been turning to commodity ETFs over the last few years. These funds provide diversified exposure over the universe of commodities and do not require the investor to directly access the futures market. Most of the funds are long-only and do not use leverage to the extent possible in the market. Some funds even store physical deposits of the commodity as does the popular SPDR Gold Trust (NYSEARCA:GLD). Most investors are not aware however that funds might be hiding a relatively unknown weakness.

For those funds operating in the futures markets, the fund must regularly roll over its contracts. This happens when the fund’s futures contracts in a commodity are expiring and new ones must be bought to maintain exposure. I won’t go into why this is a problem in as much detail as the author does, but it substantially decreases the returns to the fund.

The normal structure of futures contracts includes a ‘cost of carry’ to the commodity meaning futures contracts are priced higher than the spot. The phenomenon is called ‘contango’ and means that each time you must roll your contract to another one, you incur a cost. The author gives a detailed explanation and an example in coffee futures showing that the price of the commodity must rise by 6% annually just to cover the cost.

Contango is not always a problem. For much of the ‘90s and into the last decade, the oil market was in ‘backwardation.’ This is the term given when the term structure is downward-sloping, or futures prices are less than spot. When this happens, investors realize a gain every time they roll their contracts to the next date.

Look to the author’s explanation for more detail or visit the million sites on the internet that explain the two concepts. It is an extremely important concept if you are going to invest directly in the commodities market, but you will most likely not understand it the first few explanations (pray that you do not have to calculate the no-arbitrage futures price by hand as I had to). The action strategy discussed below, as well as the other investments discussed, do not require direct investment in the futures market. This doesn’t mean that investors should shy away from a diversifying and less volatile asset class. Put in a little time to understand the process, do not abuse leverage, and expand your investment universe.

Action Strategies

The Action Strategy accompanying this myth, available at www.jackassinvesting.com, is particularly timely. The Carry Trade is a strategy used by larger players for quite some time, but until recently it has not been available to smaller investors. Currency prices move with interest rates and inflation expectations within their respective country.

Developed markets, i.e. Japan and the United States, typically have lower inflation expectations and lower rates. This is particularly true just after recessions, as is the environment in which we find ourselves. While inflation expectations might be slightly above where the Fed would like them, we’re not looking at runaway devaluation. In fact, the Fed has committed to rock bottom rates through next year and into 2013. Contrast this environment with that seen in the emerging world.

Though many emerging market countries have postponed their rate increases due to slower expectations for global growth, their economies are still much stronger than those of the developed world and rates should stay relatively high. This kind of explicit assurance from the Fed and an analytical one from EM countries presents a considerable opportunity for investors to set up a carry trade.

The carry trade, actually an extremely common strategy used in the forex community, works by borrowing funds denominated in a low-interest rate currency and investing in a high-interest rate currency. The author sets up the example of borrowing in Japanese Yen at the one-year rate of 0.2% and investing in one-year Australian notes for 5.75 percent.

With a million dollars on each side, the investor would pay $2,000 in interest to the Japanese lender and collect $57,500 in interest on the Australian notes, for a $55,500 net profit. Since futures contracts are priced for a no-arbitrage situation, you can buy the Australian one-year contract and profit from the higher interest rate.

As mentioned, this is a common method used by hedge funds and forex traders, but regular investors do not usually have access to the lending facilities of the big dogs. For this, the author recommends the PowerShares DB G10 Currency Harvest ETF (NYSEARCA:DBV). The fund tracks the performance of the Deutsche Bank G10 Currency Future Harvest Index- Excess Return, plus the U.S. short-term interest rate. It does this by comparing the three-month rates in each of the G10 countries and then takes long positions in those with higher rates and shorts those currencies in low-rate countries.

Up to September of 2008, the fund had a correlation coefficient with the S&P500 SPDR (NYSEARCA:SPY) of only .6 providing good portfolio diversification. This correlation increased to .7 over the entire period, due to increased correlations over the last few years but is still relatively low compared to other asset correlations. Tying this back to the basic premise in the book, because currencies are influenced by different return drivers than stocks (rates and inflation expectations versus investor enthusiasm and corporate earnings) the addition of a currency strategy is a good portfolio diversifier.

Though contango is currently a problem with commodity funds, they still provide good diversification and some have done well relative to equity investments. The PowerShares DB Agriculture (NYSEARCA:DBA) has outperformed the S&P500 by about 6.6% over the last year and by 35.1% over the last five. The fund tracks the Deutsche Bank Liquid Commodity Index – Optimum Yield Agriculture Excess Return and is intended to reflect the performance of the agricultural sector.

The PowerShares DB Commodity Index (NYSEARCA:DBC) has outperformed the S&P500 by 8.2% over the last year and by 24.8% over the last five. The fund tracks a similar Deutsche Bank index, but one diversified over a wider universe of commodities. Investors may want to watch for backwardation within some commodities before committing a large percentage to the funds but, given diversification benefits, could invest now as well.

I have always liked using spreads in commodity investing. Due to substitution across many agricultural commodities, certain relationships have borne out over time. My first article on Seeking Alpha was about the breakdown in the spot relationship between corn and wheat. Increasing global demand had pushed corn prices higher while temporary weather related issues brought down the spot price of wheat. Corn has historically traded below the price of wheat, but in June of this year corn was trading at $7.08 and wheat was priced at $6.80 a bushel.

I recommended a long-short trade in futures betting that the relationship would return by the end of the year. As of Friday’s prices, spot corn was trading at $5.95 and wheat was at $6.72 a bushel for a net profit on the trade of 14.8%. This is without the use of leverage and given a diligent analysis of market factors, not an overly risky trade.

Clearly commodities are not risky, but like any financial product, uninformed investors can use them in risky strategies. With a well developed and disciplined strategy, they can be a diversifying asset class that enhances returns while lowering portfolio volatility.

Bringing this back to the “Jackass Investing” book, the point is that commodities rely on return drivers fundamentally different than the ones that drive equity prices. Clear strategies to profit from commodities are a necessary way to improve portfolio diversification from the traditional equities/bonds mix.

Source: Commodities And A Carry Trade For The Individual Investor