Roger Nusbaum on Commodities: Crucial to Know How the Market Operates

Roger Nusbaum wears many hats: financial advisor; columnist for TheStreet.com and Seeking Alpha; award-winning financial blogger. Over the past few years, Nusbaum has emerged as one of the most sensible voices in finance, cutting through the fog of product pushers to offer sensible advice that everyday investors can use. We recently met with Nusbaum to discuss the role commodities play in his clients’ portfolios.

HardAssetsInvestor.com [HAI]: We have seen new types of funds, particularly exchange-traded funds [ETFs], open up the commodities markets to new investors. Is that a good thing? And are you using commodities more in your clients’ portfolios?

Roger Nusbaum (Nusbaum): My take on the big picture is this: Basically, the fact that there are more choices is fantastic. I do, however, view all these new products as an opportunity for people to start doing stuff with something they know very little about, and either compromise their returns or take on a lot more risk than they realize. The unknowable is whether all these new investors realize the consequences of their decisions.

HAI: So how should commodities be used?

Nusbaum: I really go out of my way at every turn to preach moderation with commodities. They are a great tool that can serve one or two or three purposes depending on someone’s sophistication level. You’ll read things about how you should 20% or 25% of your money in commodities. The “money mangers” saying this don’t realize the kind of volatility that 15 percent or 20 percent commodities introduces to a portfolio.

The people I manage money for just want to have enough money when they need it without having too many knuckle white rides along the way. Commodities can be a good tool, but if used incorrectly, they can increase the white-knuckle experience.

HAI: What do you see as the key benefits of a commodities position?

Nusbaum: The primary reason I use commodities exposure is diversification. Every account I manage, for instance, has exposure to gold. I use the [the streetTRACKS GoldShares] ETF (GLD).

My premise is simple: when things get nasty—by which I mean, when there is an external shock—I expect that gold will go up. That’s what the track record shows.

HAI: We’ve seen the correlation between gold and the broader stock market tighten recently—witness what happened in February. Is the gold case still true?

Nusbaum: I don’t consider what happened to the market in February to be a “nasty external shock,” so I am not surprised that gold didn’t go up there. I don’t think it takes away from the gold case. Things like 9/11 are nasty external shocks, and the government seems insistent on telling us that that sort of thing will happen again. I have a modest weight in the portfolios: 3%-ish. That’s just one little piece that I suspect will do well if we have a nasty external shock and the market heads painfully lower.

For now, I have faith. If something horrible happens and gold doesn’t do the trick, I’ve got a whole lot more learning to do.

HAI: What other commodities do you include—or are considering including—in client portfolios?

Nusbaum: I’m favorably disposed to the concept of agriculture: food or softs exposure. I can envision, with gold at 3% in a portfolio, accessing a food commodity in one way or another for another 2%. That would be 5%, and that’s about where I want to go.

I personally own the [the PowerShares DB Agriculture ETF] (DBA). I bought it as a litmus test to get a first-hand feel for how it trades, I traded it once—it’s been pretty volatile. I sold it, and then bought back in. I want to see how it behaves for a few months before I decide that it is a product I want to buy for clients.

Going forward, I would expect that there will be more choices along these lines. I am not a fan of some of the broad-based products that are out there: with so much energy, so much food, etc. Invariably, I find myself not wanting exposure to oil, because it is simply too volatile. It is difficult for me to incorporate oil into retail portfolio, so I have zero interest in the broad-based fund. I like the idea of going narrower: it’s easier to follow the gold market or the wheat market than to be on top of all 154 commodities markets.

HAI: What about base metals?

Nusbaum: In base meals, my clients own a stock—either CVRD or Anglo-American. Generally speaking, I think the space of industrial metals is crucial, and accessing it is very important for a diversified portfolio. But quite simply, I prefer stocks. I am an equity manager, as opposed to a commodity pool operator. Generally, for my clients, stocks are also easier to understand.

Another example is copper. I recently sold—and will probably buy back in soon—one of the Chilean banks. Chile is an old story, but a good one. The economy does very well when things are good well for copper. So the bank is a beneficiary of the copper boom, but it also pays a big fat dividend, and it is probably less volatile than the metal itself.

HAI: How do you about the futures vs. bullion vs. equities question, as it pertains to gold?

Nusbaum: I am following [the new gold futures ETF from Powershares] (DGL) to see how it trades. When something new comes out, I like to give it six months or a year to prove itself out

The idea with gold is that, most of the time, I expect it to do very little. The possibility of capturing, say, 95 percent of the effect of gold … but having 4% in extra interest … could be nice. If DGL does turn out to be a good proxy for the price of gold, I suspect I will make a switch toward the end of the year.

HAI: Are there concerns about contango, and about how few people understand the term?

Nusbaum: When we last talked, I said about the oil ETF that understanding contango would not be so important as long as the fund was capturing the effect. That belied a less-than-thorough understanding of the magnitude of contago when that product first launched, which is just one of the reasons I have not accessed oil for clients. I did not expect the oil products to behave in the manner that they have.

The short answer is this: I know from talking to people and from the comments left on my blog that a lot of people managing money do not understand contango. In fact, I don’t think they have even an elementary level of comprehension about this entire [commodities] market. It is clear from the kinds of things they are asking about and the manner that they are using these products that they just don’t understand.

It is crucial for people who are going to swim in these markets to understand what they are doing and how the commodities market operates.

HAI: What else should investors be concerned about regarding commodities?

Nusbaum: The most important thing to me about accessing this space is to understand that commodities are a tool to reduce overall volatility. For people who are not looking for “action” out of their accounts, it is a great way to reduce volatility: to have something that zigs when stocks zag. But as you go heavier and heavier into the space in terms of exposure, commodities change from a diversification tool to something that ultimately increases the volatility of the portfolio. That’s critical to understand. Gold went form $720/ounce to $590/ounce in what seemed like ten minutes last year, and it is capable of making big and fast moves in other direction. If you have a modest position, the result of being on the wrong side is limited; if you have a 20% position, you’ve dug yourself a three-year hole.

Comments

[MDCigan:]

<i>I really go out of my way at every turn to preach moderation with commodities. They are a great tool that can serve one or two or three purposes depending on someone’s sophistication level. You’ll read things about how you should 20% or 25% of your money in commodities. The “money mangers” saying this don’t realize the kind of volatility that 15 percent or 20 percent commodities introduces to a portfolio.</i>

I am one of the "money managers" who has a 20% allocation to commodities. Given that fact, I felt the need to comment on what I think are some inaccuracies and incorrect implications in this interview. I respect Roger's view on this subject, but I think he is wrong.

Firstly, I think it is very important to define exactly what one means by investing in "commodities". My allocation to commodities is to a <b>broadly diversified commodity index</b>, specifically a mutual fund that mimics the Dow Jones AIG Index.

If you examine the historical data (read the Ibbotson study Strategic Asset Allocation and Commodities) you will see that the historical volatility of the Dow Jones AIG Index and the S&amp;P 500 is basically the same. If you are going to make the argument that 20 to 25% in commodities is too much because of volatility, then it doesn't make sense to have 50%+ in equities either. Again, TO BE CLEAR I am talking specifically of the Dow Jones AIG index which is broadly diversified and doesn't have huge weightings in any particular commodity like the Goldman Sachs Index.

I'm not sure I follow the argument about following gold and wheat versus 154 commodities. In my view, if you are buying a broadly diversified index like the Dow Jones AIG index then you are doing so to just get exposure to that asset class, and not pick individual commodities. You don't need to follow 154 commodities. Does somebody who buys a S&amp;P 500 index fund or Russell 2000 index fund have to follow all 500 or 2000 companies? Of course not!

In contrast, I would argue that someone who is going to try and cherrypick a few individual commodities like gold or wheat has to follow them more closely because that is more of an <b>active bet</b> on just those 2 commodities. Like Roger, I am more of a stock guy (and equity mutual funds) then a commodity guy. I don't want to try and pick individual commodities so that is why some of the narrower ETFs based solely on oil, or natural gas, or agriculture, or whatever don't really interest me at all.

In my view, Roger's statement that he is not a commodity picker, yet prefers to own just gold and agriculture over a broad index seems like an internal contradiction to me. Back to the volatility argument again, of course, an investment in "commodities" is going to be highly volatile if the extent of your commodity allocation is gold and wheat. Individual commodities are HIGHLY VOLATILE. I would NEVER advocate having a 25% allocation to just gold and wheat. But, and this is a very important point, the correlation amongst individual commodities is low, nothing like the correlation amongst individual stocks. So when you combine all these volatile commodities together in a broadly diversified index like the Dow Jones AIG, the index itself is not anywhere near as volatile as the individual constituents.

<i><i>The short answer is this: I know from talking to people and from the comments left on my blog that a lot of people managing money do not understand contango. In fact, I don’t think they have even an elementary level of comprehension about this entire [commodities] market. It is clear from the kinds of things they are asking about and the manner that they are using these products that they just don’t understand.</i>

With regard to the contango issue, this is a complex question, and right now the jury is still out on how much of a negative impact this will have on "commodity" investments. Oil has been in contango for awhile and it has impacted USO. It's beyond the scope of this reply to get into the nitty gritty here, but suffice it to say, there are alot of hardcore academic studies on this issue, and I've read and studied them all in-depth, and there is no clear-cut answer.

I'm not sure who exactly Roger is referencing in the above comments. I recall his blog posts on commodities and the follow up comments. I read and posted a note. All I'll say is I have done a tremendous amount of research on "investing in commodities". The decision to put 20% into this asset class was not reached lightly. There are some smart investors with proven track records who believe we are in a long-term bull market for commodities (Jim Rogers, Wilbur Ross). Since 2001, the Dow Jones AIG Index has substantially outperformed the S&amp;P 500:

stockcharts.com/charts...?$DJAIG,$SPX

Whether it will continue to do so over the next 5-10 years is debatable. Reasonable people can disagree. I think a plausible argument can be made that it will. If one believes it is a reasonable probability, then a 20% allocation to the broad index isn't outrageous. The Ibbotson study concludes that from the "efficient portfolio" perspective a double-digit allocation is warranted. Again, this presupposes one is investing in a broad index of commodities. Many portfolios have equity allocations of 50%+. No one would suggest investing that entire amount in 2-3 stocks, and it wouldn't be a surprise if the portfolio was very volatile if the entire equity allocation was in 2-3 stocks.

2007 Apr 26 06:03 AM

[Roger Nusbaum:]

valid criticisms. are you saying that by owning one broad based commodity index, you don't need to look under the hood and know what is going on? I feel like I would. The only commodity I own for clients is gold for the reasons stated at a very small weight as also stated.

You like broad based, I don't, so what? I do what I think is best and what I am most comfortable with as I am sure you do. You should feel free to put up a blog and express your views. Readers can learn from differing views to come up with their own thoughts about what is best for them.

2007 Apr 26 11:48 AM

[MDCigan:]

Hi Roger,

<i>valid criticisms. are you saying that by owning one broad based commodity index, you don't need to look under the hood and know what is going on? </i>

To some degree, yes. I want to know what makes up the fund or ETF, but in my view, that doesn't extend to actively following and monitoring the individual positions the fund or index holds. In my view, with respect to positions in either ETFs that track passive indices or actively managed mutual funds, I don't see how I can add any value by monitoring the underlying individual securities the ETF or actively managed fund holds.

Not to beat a dead horse, but in my view, there is no difference in owning a broad commodity index versus owning a broad REIT index, an emerging market index, or a domestic equity index. It would be absolutely impossible to regularly monitor every single individual holding in each index, and I can't see any value or alpha from doing so. I do have some individual equity positions (Berkshire Hathaway and Chesapeake Energy) and of course do substantial research and monitoring on those.

<i> You like broad based, I don't, so what? I do what I think is best and what I am most comfortable with as I am sure you do. </i>

No prob. I respect that, and I'm not trying to change your mind. My main point is that your point about excessive volatility from a 20 to 25% allocation to commodities only makes sense in the context of owning a few commodities and isn't applicable to owning a broadly diversified index like the Dow Jones AIG. The Goldman Sachs Index is a different story. For all practical purposes, it is basically equivalent to owning the oil ETF. It would be like the S&amp;P 500 being 70% General Electric.

<i>You should feel free to put up a blog and express your views. Readers can learn from differing views to come up with their own thoughts about what is best for them. </i>

Maybe some day. Right now, I just don't have the time to regularly post to a blog. I enjoy your blog immensely, and have alot of respect for the fact that you post very regularly.

2007 Apr 26 10:14 PM

[MDCigan:]

Ugghhhh, it really sucks that there isn't a preview post function here on seeking alpha. I keep screwing up the HTML tagging with respect to quoting someone else and my own comments. Over on Motley Fool, there is a preview post, and you can go back and fix mistakes.

2007 Apr 26 10:17 PM