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Because of renewed fears of inflation, there has been considerable interest in Commodity Funds as of late. For good reason: during that last bull market, commodities experienced a great run-up in prices.

On The Plus Side

• Commodities are an excellent inflation hedge.
• Commodity Index Funds have historically provided superb diversification benefits.
• In recent years, many new commodity ETFs and ETNs have come on the market. These new products have made it easier for the retail investor to obtain exposure to commodities.
• Many academic studies have shown that a diversified basket of commodity futures historically have had equity-like risk and return characteristics, while being negatively correlated with stocks.

Various Commodity Index Funds are available. To learn more about these indexes, fellow Seeking Alpha author Don Dion wrote a comprehensive article titled “The Ultimate Commodities ETF Guide” http://seekingalpha.co...

Not All Commodity Indexes Are Created Equal.

A large number of academic studies have been published that show the superior performance of commodity indexes. The authors have shown that a diversified basket of commodity futures have provided equity-like risks and returns, while being negatively correlated with stocks. There are three competing commodity indexes. When compared over several decades, the out performance occurred in only one of the indexes, whereas the remaining two commodity indexes had meager performance. The difference in performance is dependent on the criteria used to construct the basket. Could this be due to data mining? Even if the out performance is not due to a data artifact, the investor still has only a one-in-three chance of picking the highest performing index.

The Jig Is Up

While the superior performance of commodities has occurred in the past, it is clear that investors have caught on, and have flooded the market to chase returns. When too many people know about a good thing, it no longer becomes a good thing. In a recent research paper written for the Bank of International Settlements  titled “Financial Investors And Commodity Markets” http://www.bis.org/pub...  the authors raise the concern that Commodity Markets have grown too big for their pants: 

Financial activity in commodity markets is large compared with the size of physical production and has grown much faster in recent years. For gold, copper and aluminium, the volume of exchange-traded derivatives was around 30 times larger than physical production in 2005 – a significant increase in this ratio from 2002

Yes Commodity Futures have a negative correlation with other asset classes. It appears that the outsized long-term gains of the past will no longer be true in the future. Maybe Commodity Index Funds will still provide excellent diversification benefits, but the long-term returns going forward are sure to be lower. As one financial expert quipped “you can’t eat negative correlations”

Diversification Benefits Are Decreasing

In the same BIS report, Alexandra Heath and Dietrich Domanski write:

the share of non-commercial net long positions appears to have been less influenced by perceived diversification benefits than in the past. In the earlier subperiod, before prices started to accelerate, there is a negative relationship between investor activity and the correlation between returns on commodities and world equities in most cases. In the second subperiod, this relationship is either statistically insignificant, or has a perverse sign.

Counter-Party Risk

Many Commodity Index Funds are structured as Exchange Traded Notes (ETNs). Unlike ETFs, the much riskier ETNs expose the investor to counterparty risk. During the global financial crisis, Lehman had backed a large number of ETNs. Investors at the time were   extremely nervous about their exposure to Lehman and many were forced to sell their positions, at the worst possible time, in order to eliminate the risk of a Lehman default.

Summary

• Studies have shown that due to overwhelming investor interest, commodities are in danger of losing their diversification benefit.
• The investor has a one in three chance of choosing the index with superior returns.
• Commodity Index Funds are expensive to hold, the typical ETF and ETN charges 0.75% in annual expenses.
• Most of these funds use the ETN structure with its inherent counter-party risk.
• Due to enormous investor interest, the outsized long-term gains from commodities is the past, will not be repeated going forward.

While the commodity asset class is suitable for the speculator, it is unsatisfactory for the prudent investor. The prudent investor would be wise to avoid this asset class.

There are better investments that protect you from inflation. If you are interested in alternatives that are cheaper and less risky than commodities, please look at the following articles, I have written on the topic:

WIP and TIP: Better than Gold

TIPS: Good in Deflationary and Inflationary Times

DISCLOSURE: Author holds no position in commodity derivatives. You should perform your own due diligence and consult with a professional before investing.