I was away almost all day on Friday participating in an inter-agency drill with the Fire Department. While I was away a ton of comments came in on the post about Jim Rogers recent comments. I'll try to answer/weigh in on some of this stuff.
TomK was first up with a quick look at a couple of the different index (made into ETFs) compositions and notes some big differences. He then offers up a reasonable assessment of what seems like poor returns more often than not (probably true) and some of the downsides to owning this space.
Regardless of what you think of TomK's comment there needs to be an introspective assessment of why you own commodities or why you want to buy commodities in the first place. My reason from the start has been to have a little bit of exposure, like 3% little, in something that will zig when the market zags. I think the easiest way to do this is with gold, this may not be the best way for a given time period, but it seems a little simpler and historically it does go up during external shocks (I don't think the dip that started on February 27 was an external event).
I would expect that if my commodity exposure is doing really well stocks may not be doing so hot. It does seem that the correlation to stocks has been doing some weird things over the year so maybe something has changed; we'll see after the next external shock.
Dismally Dave (http://www.dismally.com/) seems skeptical that a bull market in commodities could last until 2022. Well I don't know. There is some history that suggests commodity bulls last for years but yes 2022 seems like a very long time. For now the general outlook seems positive. I am more focused on what is going on now and what I think might come in the next year or two.
Another reader asked about PowerShares Agriculture ETF (DBA). I own this one personally. I bought it as a trial balloon to see if it might be right to incorporate into client accounts. It is a little more volatile that I thought it would be and I am leaning toward not using it for clients.
This fund is 25% each in corn, wheat, sugar and soybeans. When I see a big move in DBA I just look at a quote for each component. On MyYahoo page I have one stock list with all the commodity ETFs from ETFSecurities that trade in London. Sugar is SUGA.L, wheat is WEAT.L, corn is CORN.L and soybeans is SOYB.L.
As one reader noted sugar was down a lot. These are not necessarily the best way to look at what commodities are doing but you can capture almost all of the effect and it very easy.
I would say that on a given day a commodity can do anything regardless of the fundamentals. A reader makes a good case for why the commodities that underlie DBA should go up and I suppose he is right but Friday they went down anyway. Sorry to be too obvious but stocks or commodities or whatever often do what they should not.
A couple of comments drifted into commodity portfolio construction. If you believe that commodities offer low correlation to stocks yet stocks have an up year 72% of the time how much do you really want in commodities? As noted clients have 3%-ish in GLD. If DBA were less volatile I might add 2% there.
I would think that 20% in commodities would create a big drag on the portfolio, another 15 years of bull market notwithstanding. Even if that is wrong I think it would add a lot of volatility to a portfolio, an awful lot.
I'll close out by saying the commodity ETFs are a great idea, I'm glad there is some choice in the space and there will be more to come but it feels like the type of thing that will be over used. I have never understood the thought that 20% should be in the space. On May 11, 2006 GLD printed above $72. On June 14 it went below $56. As noted above DBA fell 3.5% on Friday.
You should expect that when you add commodity exposure you are adding volatility. This may not be a bad thing but I think that a lot of folks are going to end up with too much exposure.
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18 comments:
http://tinyurl.com/qzs9b
The above link is to Patrick Byrne's presentation on short selling that was topical last week. He is also being interviewed by J. Puplova today.
Every 30 years they last about 9 years. (2001-2010)
I thought a bit about that comment. I pegged oil out of the crowd. That's one commodity that we're seeing substitution being considered. But, Jimmy may be on to some things that I overlooked. How about concrete? Put together 1.3 billion Chinese, and tell them they can have a better life. Then let them build it. Certain commodities aren't really replaceable. Copper is another, of course.
Who benefits from this? Australia, for one. China is trying to catch up to the Western world's standards. These commodities are going to continue to be in demand.
However, I'm going to stick to my guns that other commodities are going to be replaced. Just look at the corn report from this week. The biggest planting in 60 years. All to keep up with demand for ethanol.
cement benefits Australia? I thought Rinker made most of its cement elsewhere meaning that a cement boom helps Rinker but not sure about Oz in general.
Unless James Hardie makes a lot of cement?
David do you have any followup? TY.
Just to clarify, I would never allocate 20% to commodities in a buy and hold portfolio. In fact, I wouldn't allocate 2% to commodities. Over the long haul commodities tread water - I would rather use timing or bonds to reduce volatility.
The idea is to own commodities only when they're in a long term uptrend (above their 200 day moving average) and park the position in cash when they're trending down. Ideally there will be periods when commodities are up when equities are down.
I'm going to try and cajole Mebane into publishing an equity curve of his TAA timing stategy.
This is a good discussion, and Roger, I love your site.
Commodities are a volatile asset class, but they can reduce the overall volatility of a portfolio. I don't know if the bull will charge till 2022, but I do believe this asset class deserves a home in any portfolio. I use a higher percentage for clients, anywhere from 5-10%. If you want to read a great analysis on asset allocation I highly recommend Roger Gibson's work on portfolio management.
First, great blog. I recently discovered it, and enjoy reading it and your articles on seeking alpha.
I did feel compelled to respond to a few points in this piece. I am an investment advisor, and have a roughly 20% allocation to commodities in the PIMCO Commodity Real Return Fund which mimics the Dow Jones AIG Index.
TomK was first up with a quick look at a couple of the different index (made into ETFs) compositions and notes some big differences. He then offers up a reasonable assessment of what seems like poor returns more often than not (probably true) and some of the downsides to owning this space.
Not sure where the "reasonable assessment of poor returns comes from". It is well beyond the scope of this reply to get into serious detail, but I'll simply point out there was an academic study out of Yale that demonstrated that a diversified basket of commodity futures has historically produced returns that matched stocks. On an anecdotal basis, my holdings in the PIMCO fund did great in 2004 and 2005, basically flat in 2006, and so far OK in 2007.
Regardless of what you think of TomK's comment there needs to be an introspective assessment of why you own commodities or why you want to buy commodities in the first place.
In my view there are 2 main reasons:
1. Portfolio diversification - adding another negatively correlated asset class that historically has produced positive returns
2. Capitalize on the long-term secular bull market in commodity prices. I agree with Rogers that it has many years to run. I'm not sure about 2022, but we are only 6 years into the commodity bull market. Based on my research, it seems to me most major bull markets at the asset class level last at least 10 years if not significantly longer.
A couple of comments drifted into commodity portfolio construction. If you believe that commodities offer low correlation to stocks yet stocks have an up year 72% of the time how much do you really want in commodities?
This statement is puzzling. It seems to conflate/confuse returns with correlations. It is entirely possible for 2 asset classes to provide positive returns in the exact same year yet still have low or negative correlation.
I would think that 20% in commodities would create a big drag on the portfolio, another 15 years of bull market notwithstanding. Even if that is wrong I think it would add a lot of volatility to a portfolio, an awful lot.
This is just wrong, on both points. If you accept the premise of a commodity bull market, then it doesn't make sense to believe it would be a drag on overall portfolio returns, unless you believe that stocks will be in an even greater bull market.
I'd highly suggest reading the Ibbotson study:
http://www.pimco.com/LeftNav/Viewpoints/2006/Greer-+Ibbotson+Commodity+QandA.htm
Because commodities produced high returns with low correlations to other assets, the Ibbotson study found that including commodities in a strategic asset allocation opportunity set produced returns that were significantly higher at any given level of risk relative to returns when commodities were excluded from the opportunity set.
Q: And what did Ibbotson conclude regarding the optimal size of an allocation to commodities going forward?
Greer: As I mentioned previously, Ibbotson projected future commodity returns using three different methods: the capital asset pricing model, the building-blocks method and a combination of the first two methods.
The optimal allocation to commodities varied depending on the method. At the 10% standard deviation level—a moderate risk level similar to a standard portfolio of 60% stocks and 40% bonds—the optimal allocation to commodities ranged from about 22% using the capital asset pricing model to as large as 28.9% using the building-blocks method. Even at the conservative 5% risk level, optimal allocations to commodities were relatively large, ranging from about 9% up to nearly 14%.
Regardless of the method used in projecting future commodity returns, portfolios that included commodities in the opportunity set were also more efficient than those that excluded commodities, based on the Sharpe Ratio.
So from a portfolio optimization perspective, I think 20% is actually just about right. I think it is still the somewhat unconventional view despite the fact that the studies and detailed quantitative analysis supports it.
Like I said before, I don't know snot about commodities, but this chart doesn't exactly inspire confidence in using commodities as a long term holding:
http://tinyurl.com/2aba8b
If you're using a timing overlay, that's a completely different story.
Tom K,
I read the Ibbotson study and it tried to address the fact that eventhough commodoties averaged a low return (almost zero), it was still possible for an investor to get an actual return close to 9 percent. How is that possible? Part of the explanation ( If I read it correctly, has to do with the fact that :
1. When you invest in commodities you are actually investing in futures contracts (not the actual commodity) which has its own small return.
2. When you "buy" $1000 dollars worth of ,let's say, corn through the futures contract, you are only putting up a small amount of money, the rest of the money goes into treasury bills. So most of the return actually comes from the treasuries!
What I find impressive about the study is the non-correlation with stocks, which other than low returning bonds, is hard to find.
I am just a drop suspicious that the research was paid for by a company that sells a "commodity" fund. It is like the chocolate companies paying for research about the benefits of chocolate.
Only time will tell if these commodity funds have a considerable place in a portfolio.
Glen
Like I said before, I don't know snot about commodities, but this chart doesn't exactly inspire confidence in using commodities as a long term holding:
http://tinyurl.com/2aba8b
Well, I suppose it depends on how one defines "long-term". Over the very long-term (50+ years), there does seem to be a downtrend in commodity spot prices. However, as can be seen clearly from the chart you linked to, there are long-term cycles of increasing commodity spot prices that can last 10-25 years, so-called "commodity supercycles". The question is are we in one now, and does it have many years left to run (this upcycle began in 2001, has it essentially peaked 6 years later?)
I've read enough, and researched enough to answer that question for myself and allocate accordingly.
1. When you invest in commodities you are actually investing in futures contracts (not the actual commodity) which has its own small return.
Yes, the returns come not just from changes in the spot price, but from the "roll yield" of rolling futures contracts in backwardation. There is some debate about whether this source of return is sustainable, and whether backwardation or contango is the typical state of affairs. My understanding is that some of the commodity ETFs are running into the opposite problem, where they are actually losing money from rolling contracts in contango. I think this may be happening to USO and the Oil Up and Oil Down ETFs over the past year.
I can't honestly answer this question, and it is something I am trying to get a clearer understanding of. In any case, I believe that increases in the spot prices of commodities over the next several years will trump any concerns about rolling contracts in contango.
2. When you "buy" $1000 dollars worth of ,let's say, corn through the futures contract, you are only putting up a small amount of money, the rest of the money goes into treasury bills. So most of the return actually comes from the treasuries!
To some degree, yes. But again, if one believes in much higher commodity prices, that trumps everything else. If oil is $150 a barrel in 2015 or 2020, that percentage increase is more substantial then the interest earned on the collateral invested in T-bills.
I am just a drop suspicious that the research was paid for by a company that sells a "commodity" fund. It is like the chocolate companies paying for research about the benefits of chocolate.
As far as I know, Ibbotson is a widely respected research firm that is highly credible. I believe they are now a division of Morningstar. I suppose anything is possible, but I highly doubt PIMCO paid them to reach a specific conclusion even if the research pointed in the other direction.
Only time will tell if these commodity funds have a considerable place in a portfolio.
Yes, this is true, but I suspect most will take too long to reach a conclusion. I've owned the PIMCO Commodity Real Return Fund since early 2004. It beat the S&P 500 in both 2004 and 2005, and lost in 2006, and has served the function of being a diversifier.
If I am correct on the thesis of a commodity supercycle, my guess is most people will finally be substantially increasing their allocations to commodities just as the cycle is peaking and perhaps entering bubble territory, just as we saw record inflows into Technology, Internet, and Large-Cap Growth in the late 90s.
Interesting factoid. Back in the 1950s and 1960s, many institutional portfolios and especially bank trusts did not believe stocks belonged in a portfolio except as "speculation". It was the experience of the 30s and 40s that led to that incorrect conclusion. It took the bull market of the 50s and 60s to reverse that thinking. Unfortunately, by the time people came to believe that stocks belonged in a portfolio, the major indexes were hitting peak values that wouldn't be seen again for 20 years. Ironically, in the late 60s and early 70s the right move was to decrease stock allocation and increase commodity allocation. Even more ironically, many pension funds decided to add commodity allocation in the late 70s and early 80s, just as the right move was to be decreasing commodities and increasing stocks. I'm a firm believer that the big money is made investing in areas that are contrarian and have high degrees of skepticism. Who was saying to load up on REITs in 2000?
A couple of additional quick points:
1. In addition to the Ibbotson study, I would highly encourage reading the original Yale study which is cited in Jim Roger's book. I would also read all the subsequent academic studies that have been completed in response to the Yale study. In my opinion, I can't even imagine making an intelligent, informed decision about whether to add commodities to a portfolio and in what percentage without having thoroughly read and studied those papers.
2. Unless I missed it, nobody has mentioned one of the substantial benefits of commodities in a portfolio, and that is as a hedge against the U.S. dollar. Most commodities trade based on worldwide supply/demand issues and to the degree that the U.S. dollar loses value relative to other currencies, the U.S. dollar denonimated price of commodities will increase. I believe it is a high probability the U.S. dollar is in a long-term structural decline that won't reverse unless we address and fix our trade deficit, budget deficit, and debt level issues, and I'm not sure the political will exists to do so.
Hey Mike,
I find these commodity funds scary because some of them have had over 50 percent losses. Many of them are overly heavy in oil. Despite most people's view that oil can only go up, I think that when the economy slows, oil will come down. Since the long term return for commodoties is close to zero, I find it hard to keep it as a permanent asset allocation.
The new managed commodity fund (Rydex) does not have to depend on prices going up because they take long and short positions. So I am probably going to use that one, and then use a fund like PIMCO after commodoties (mostly oil)comes down.
Where do you see a good contrarian area for investment?
Glen
I find these commodity funds scary because some of them have had over 50 percent losses. Many of them are overly heavy in oil. Despite most people's view that oil can only go up, I think that when the economy slows, oil will come down. Since the long term return for commodoties is close to zero, I find it hard to keep it as a permanent asset allocation.
Hi Glen,
I'm guessing you are referring to either funds or ETFs based on the GSCI index or pure oil funds like USO when you mention 50% losses. A broadly diversified commodity index hasn't experienced drawdowns anywhere close to that level:
http://stockcharts.com/charts/performance/perf.html?$DJAIG,PCRDX
In fact, the Dow Jones AIG index isn't that far below its multi-year high because despite the fact that oil is off its high, agricultural commodities haved done well. Off the top of my head, I think oil is 12% of the DJ-AIG index where it is 70% of the GSCI.
In my view, buying a commodity fund that is based on an index that is 70% oil doesn't make sense. It would be like buying a stock index fund that has 70% in a single stock. Where is the diversification?
I could be wrong, but I am not sure most people's view is that oil can only go up. I agree with you that oil is probably headed downward if and when the global economy slows, but I think that is a temporary thing that doesn't affect where oil might be 10-20 years from now.
The new managed commodity fund (Rydex) does not have to depend on prices going up because they take long and short positions. So I am probably going to use that one, and then use a fund like PIMCO after commodoties (mostly oil)comes down.
I don't know anthing at all about the Rydex fund, but I would want to know ALOT about who is managing the fund. What qualifies them to be active commodity pickers? How do they know which commodities to go long and which to go short? Do they have a track record of success in this area? Without knowing more, I think this could be more risky then owning a broad commodity index that is long everything. What if the fund has horrible active managers who are long everything that goes down, and short everything that goes up?
Where do you see a good contrarian area for investment?
Well, I still believe commodities and precious metals are contrarian investments, although not anywhere near as contrarian as back in 2001. Who was suggesting commodity and precious metals investments back in 2001? Very, very few. 6 years later we are debating about 2% to 5% allocations, and 20% allocations is considered by most to be very unconventional. Contrarian is by definition the opposite of what is conventional wisdom.
Right now, I'm finding it hard to find additional contrarian ideas. There doesn't seem to be any particular asset class, sector, or industry that is universally despised or overlooked.
Maybe homebuilders. I have XHB on a watchlist. There still seems to me to be too many people trying to call the bottom. I don't get the same sense of disgust that the NASDAQ and tech had at the end of 2002. I think there was clearly overbuilding, and unsustainable home price appreciation but I don't think it is the end of the world.
I'm not sure how contrarian it is, but large-cap high quality is probably the most attractively valued segment in U.S. stocks.
GMO, which is a top-tier investment firm posts for free on their website, their forecasts for long-term returns across major asset classes. I find it useful in helping me to determine my allocations.
https://www.gmo.com/America/MyHome/default
https://www.gmo.com/America/CMSAttachmentDownload.aspx?target=JUBRxi51IICANcPenAXxYESMOo2n%2bENupblgEBmR7F88bSxfLNUZDzlqFqUSnh%2bJbksSdl1G2ppeAM0tp8bJ85D%2bLPSrLUOQZb3bADmj3a4%3d
You either look at the CCI (NYBOT) , Sectorial indices or individual commodities, all rest ****
commodity charts
Hi Mike,
I agree with you on the risks of "managed" futures.
A few years ago I was looking for a managed commodies broker and found one that required a relatively low entrance investment. I decided not to do it and then a few years later the firm went out of business. The few that I was able to find had terrible track records. If there are any good commodity managers, I certainly can not find them
The Rydex fund (symbol: rymfx) is not "managed"-- it tracks an index called somethng like "S&P Trend Index." The results of the index were very impressive (about a 8 percent return with a volatility of less than five percent.) (That return does not include expenses which would certainly lower that return.
I have more to say, but I have to go now.
P.S Thanks for the heads up for GMO
To Troy: what do you mean by "sectorial"-- industry sectors?
Glen
The idea of an agricultural ETF is very interesting.
Climate scientists have long suggested that reduced yields are the most likely outcome under global warming, and with the declining trend line of improving yields through artificial means, one has to wonder whether the old Maltusian scenario might be coming alive.
In that case, I suppose, an agricultural ETF would benefit the most from some sort of high inflation world order, chasing basic foodstuffs.
In that sense, it might be like a long-term insurance policy.
Jay Walker
The Confused Capitalist
Hi Mike,
...continuing from last post:
I checked out PIMCO and although its energy allocation (different kinds of oil and gas) is lower than the others, it is still about 30 percent, which still seems high to me. I also checked the history of the underlying index which did show about a 30 percent drop a few year ago (before PIMCO's fund). Compared to the others, PIMCO's fund seems the best. But I think I am a little too late to jump on for this cycle.
Glen
Sectorial indices= GFMS base metals ... for example, see
commodity charts
for more details on commodities ...
Troy
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