Commodities... Are They Different From Securities?

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by: Kurt Dew

Summary

A common misapprehension among investors is that commodities are for trading; securities, for investing.

This proposition is mistaken for two reasons: First, trading and investment are not separate activities.

Second, commodities returns do not require a separate predictive model from securities returns.

Sooner than later, the entire distinction will vanish.

I can see no way… I've been a fool and I've been blind. And I'm damned if I do and I'm damned if I don't.

-- Florence + The Machine

From time to time, a financial writer opines that trading in commodities is dumber (wiser) than investing in securities. Horsepatooties. Twice. Once because there is no material difference between investing and trading. Twice because there is no material difference between the behavior of commodities returns and securities returns.

The difference between securities and commodities investment will soon rest in the ash heap of bygone notions.

One case for the superiority of securities investment to commodities investment argues that securities are productive; commodities, not so much. Because: signposts such as income and capital gains, produced by securities, but not by commodities are advanced as indicators that securities are more productive. See for example, the recent Bloomberg article by Ben Carlson. In this article, Carlson opines that the chart below reveals something of use to investors and traders. The claim is that the chart shows that commodities markets are not for investors, but for traders.

Charts, charts, charts

Like most charts, this one reveals an apparent relationship from which the baptized may profit. Over the decades since the introduction of the Capital Asset Pricing Model (CAPM), a near-infinitude of such charts, comparing investments, has been constructed. The charts all work perfectly when applied to past prices. But none work so well when applied for a few years into the future. This chart, and for that matter, all charts, is a symbolic representation of the reason for the flood of money into index ETFs [Vanguard, BlackRock (BLK)]. Activist strategies, when compared to passive index-based strategies embodied by index ETFs, do better in any period of one contiguous year about 10% of the time. In the following year, something close to 10% of the activist strategies do better again, but the new outperformers very likely differ from those of the previous year.

For classic analyses of two schools of thought about the predictive value of charts, see Fama here, and Thaler here. Do charts identify predictable positive values of alpha (that which this site seeks)? Fama and his supporters, on one hand, contend that a model that assumes randomness of alpha yields the “best” (most representative) model of future investment returns; Thaler and colleagues, on the other, argue that there are identifiable deviations from the predictions described by Fama’s random-alpha model, due to investor irrationality.

The salient fact for readers of this article: both groups contend that actual trades that benefit from charted evidence of alpha are somewhere between scarce and nonexistent.

The problem with charts

So, this chart may be interesting to Carlson, but not to me. It purports to demonstrate that commodities create trading profits, but not investment profits. I have two problems with that assertion. First, for investors playing with their own money, the difference between trading and investment is mute. Second, if we buy the story of the chart, a donkey would have bought the ratio in 1971, sold it in 1973, shorted it in 1990, bought it back and doubled down in 1998, then finally shorted it again in 2007. But the real issue is, what of future performance? Buy again? Not me. That the donkey will follow the previous path is not obvious to me.

Are trading profits and strategies different form investment profits and strategies?

This distinction escapes me. Presumably investing is something one does infrequently, whereas trading is something one does frequently. People who bandy these two words about claim seem to know what they mean. I, for example, apply the words to my own activities.

When I was a financial institution’s trader, I knew what that meant. It meant I did nothing but buy and sell things, or consider what to buy and sell, all day long. Also, I noticed that I worked in an area called the trading room, and marked my portfolio to market daily as traders must do in trading rooms. Within financial institutions the difference between trading and investment is enshrined in the accounting treatment of instruments being acquired or sold. Investment income is recorded on a deferral basis; trading income, on a mark-to-market basis.

When I quit trading, I considered myself an investor. The only thing I do with my investments is look at their performance with pleasure or regret. I buy only index ETFs, and with spare cash.

But most market participants at retail fall within these extremes. And for these average investors I see no value in asking when they are trading; when, investing. Returning to Carlson, the chart above suggests what Carlson considers to be a trading strategy.

The chart suggests that a donkey could have generated trading profits by selling commodities and buying securities at the ratio peaks, and reversing the trade at the dips. This is useful if you have second sight. From the chart, the peaks and dips are sometimes the result of events in the oil market, sometimes the result of events in the stock market. If we had a copy of this chart, at the outset, in 1971, we would all be languishing on the decks of our yachts, somewhere in the Caribbean, right now. (Unless you are some kind of hippie freak, and find happiness in a commune in Oregon. So retro.)

But the same is true of all charts. The reality is, using charts of past prices to predict future prices is not a job for a donkey. Perhaps a wizard or a fortune-teller.

How does trading differ from investment?

Carlson suggests that investing depends on rock-solid matters such as return on equity in the form of dividends and capital gains, which tend to grow slowly but faithfully. Commodity price changes, on the other hand, are exactly that. Changes in the commodity’s price. But this is a distinction without a difference. Forecasts of future value of all investments, at any point in time, rely on the Law of One Price. This law states that for all liquid storable commodities and investments, the expected future price depends upon the cost of carrying the investment in question. The interest cost of financing inventory of the instrument. This interest rate, according to the Law of One Price, is the risk-adjusted return. This return is as relevant for a commodity as for a security. Any tradable asset, whether commodity or security, belongs in the theoretical asset portfolio of CAPM. Nowhere in this theory is a distinction drawn between trading or investment, nor is a distinction drawn between securities and commodities. Why? Outside the corporate world, where accounting rules force employees to designate themselves either investors or traders, there is no difference.

Are commodities investments different from securities investments?

The answer to this question is a qualified “yes.” Commodities differ from securities due to the effects of the far higher cost of taking possession of commodities, compared to securities. To a degree that varies among commodities (important for commodities like live animals; unimportant to commodities like precious metals) delivery parameters such as the delivery date, location, and quality of goods require investors to incur higher delivery costs in acquiring physical possession of commodities.

Hence the birth of futures as a way of trading commodities. But not because commodities appeal to an investor universe, traders; while securities appeal to a more conservative investor universe, investors.

The future of investment/trading

The more interesting moral of the false distinction between commodities and securities returns is this: The mistaken notion that commodities are for trading; securities, for investment, will soon lose its last justification.

Futures are important for their settlement and margining technologies; not because they are pricing commodities instead of securities. Futures technology makes sense in every market. What is futures technology? The answer:

  • Frequent market valuation of all open positions with immediate transfer of gains and losses.
  • Ownership separate from control of value.
  • Ownership transfer based on right-holder discretion, with delivery parameters specific to settlement costs peculiar to each security/commodity.

The fact that will ultimately bring down the edifice of separate CFTC/SEC jurisdiction is this: the ideal technology of market infrastructure does not directly involve a distinction between the future price and the present price of a financial instrument. Nor is there a point to the false distinction between a “derivative” instrument and an “underlying” instrument. The reader may find this latter argument here.

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.