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

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.

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

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.

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

<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.