Self-Evident Commodity Truths

By Brad Zigler

Pundits are now pondering if America declared another sort of independence this July - from the stranglehold higher commodity prices were putting on its economy. Now a month out, we can look back to assess things a bit more dispassionately.

It's really a matter of perspective. If you're a consumer - and who among us isn't? - you're bred to detest inflation. After all, who wants to pay more for stuff? And what stuff is more basic than commodities like soybeans or crude oil? On the eve of the Independence Day holiday, we reflected on the inflationary trends for both those commodities ("Independence Day Memories") during George W. Bush's tenure.

As an investor, however, your feelings toward inflation can be mixed. Sure, inflation erodes your purchasing power, compromising the value of cash flows. But rising stock prices are an inflation in their own sense. And who, but chronic bears, complains about that? Ultimately, though, virulent or systemic inflation is a negative for the stock market.

Now that commodity exposure can be tapped by workaday investors through exchange-traded vehicles such as funds or notes, inflation hedges can be quickly and efficiently overlaid on a lot more portfolios. Some folks, however, are using ETFs and ETNs for more than just hedging. For these, commodities are at the core, not at the periphery, of their investments. By overexposing themselves to commodities, these investors allow all that stuff to hold their portfolios hostage.

Matt Hougan assessed the year-to-date performance of a slew of commodity ETFs (For ETFs, First Half Was All Commodities) through July 1. Indeed, commodities were the darling of the ETF asset classes in the first half.

Broad-based commodity ETFs include the iShares S&P GSCI ETF (GSG), the PowerShares DB Commodity Index ETF (DBC) and the more recently introduced GreenHaven Continuous Commodity Index ETF (GCC). A quick look at their price trajectories updated through July shows what some investors hope is the beginning of the end for commodities' ascendancy. And what other investors - those overweight in commodities - fear most. 

Broad-Based Commodity ETFs Year-To-Date

 

Through July, the iShares GSG portfolio rose 45%, offering a reward-to-risk ratio of 3.6-to-1. The other funds followed suit to varying degree.

Performance: 31-Dec-07 through 03-July-08

	Period Return	Risk (Volatility)	Annualized Reward-to-Risk
GSG	44.8%	29.3%	3.6
DBC	47.1%	25.7%	4.4
GCC	21.9%	25.1%	2.2

 

Then, the commodity darling turned brattish after the Fourth of July. The iShares ETF lost 15%, largely due to weakness in the oil market. The other portfolios lost ground as well, though the GreenHaven fund's loss was tempered because of its lighter exposure to energy futures. 

Performance: 03-July-08 through 31-July-08

	Period Return	Risk (Volatility)	Annualized Reward-to-Risk
GSG	-15.8%	32.1%	-2.7
DBC	-23.0%	27.6%	-3.0
GCC	-9.8%	23.6%	-3.1

So, is this really the first leak of air from the commodity bubble? Should you bail from all the hard asset stuff and go back to cash, stocks and bonds? Or is this only normal volatility within a secular bull market?

There are arguments galore for both views. One thing is certain, though, volatility's a two-edged sword (Tale Of Two Volatilities). Swung too broadly, i.e., getting overexposed, it can cut you deeply.

Comments

[JasonC]

The average return of commodity indices over the past 20 years is only about 5% per year. Yes they are strong this year, while other asset classes that look good in a long rear view mirror did poorly (large cap value, commercial real estate e.g.). This is just the usual story of asset classes giving fairly random returns from year to year.

A modest weight in commodities can make sense, because they tend to zig when other assets zag. But hugely overweight positions in them are a Bad Idea. It is performance chasing and market timing at its worst.

In the long run, the reason commodities have punk returns is they produce no new income. Yes they benefit from large scale inflation. With sufficient lags, so do other assets - people won't lend forever at negative real rates - some with much lower risk. Also in the long run, real estate is at least as good an inflation hedge and actually produces significant current income, as well. It just got too overpriced recently, leading to a vogue for commodities as a replacement inflation hedge.

Do your homework on diversification and asset allocation models. Don't chase the last quarter's performance and expect it to continue forever. That's just a way to get fooled by randomness and pay extra for volatility instead of being paid to stand it.

[bbzz24]

and the 20 year return on high yeild bonds and real estate is not much better than 5%. and equities in the past 10 years are at break even. if you dont adjust cyclically your portfolio you will be barely keeping with inflation (reported, not actual).

diversification is way of averging your return: like a football team with few highly paid stars and a bunch of rookies to bring the payroll down. it helps the uneducated and unsophisticated investor, and is a drag to investors who can play both the long and short side of the asset classes they specialize in.