All Things In Moderation, Even Commodities

This might whip a couple of people up but yesterday I was reminded of point I have made quite a few times in the past and thought it would be worthwhile to revisit again. Yesterday I read an interview with someone generally thought of as an ETF expert that focused on his opinions about various niches in the commodity market. The interviewer also managed to tie in the potential complexities of investing in commodities caused by the structure of the futures curve; contango or backwardation.

From the start I have been very consistent in advocating for a little exposure primarily with gold, which we target at 2-3% of a portfolio, and occasionally a 2-3% exposure to something else and that is it. We owned PowerShares Agriculture Commodity ETF (DBA) for a while but have since sold it. In past posts I have mentioned coffee as having long term potential on the idea that a little penetration into China and India from the current microscopic number up to a slightly less microscopic number could be a big driver for the price (I don't think it will ever come anywhere close to tea consumption). Of course lately coffee has been white hot.

The reason I believe in gold as a core holding is that no matter what the price is today, I would expect it to go up if something bad happened tomorrow. Against that backdrop having one or two things that could go up can help absorb some of the blow that an external shock might cause. If it goes up for other reasons while we hold it, that is ok except that, as I have said before, if gold is the best performing thing you own then chances are the rest of the portfolio is not doing too well.

My reason for believing in a small allocation used to just be about the potential volatility. Commodities are volatile, seemingly more so than equities (subjective comment). When you put 20% of your portfolio into a very volatile asset class you change the volatility characteristic of your portfolio and at some sized allocation the exposure goes from being a portfolio diversifier to being the portfolio.

Another thought that I may have touched on previously but I think is going to become a big deal, if it isn't already, is the extent to which the easy access to commodities from exchange traded products for investors who previously never even considered commodities is or will distort the commodity markets. Do a little digging and it will be clear that many of the markets now available through ETPs are very small. That there could be some sort of unintended consequence from all of that capital should not be a black swan to anyone.

The bullion backed funds (I am not in the camp that says they are a fraud) should not be hurt by something unexpected in the futures market, although this is not impossible, but the futures based ETPs could be hurt--by definition. A 2-4% portfolio exposure in a space that malfunctions is unfortunate but that is all it is; unfortunate. A 20% exposure in a space that malfunctions could be catastrophic.

In addition to a little exposure to commodities it is also valid to have exposure to parts of the stock market that benefit from commodities. I don't view one as a substitute for the other but as a way to capture what some have said is a 17.6 year cycle with quite a few more years to go I would think that the stock of a Colombian coffee plantation (if there is one) or a palm oil plantation stock from Asia (there are quite a few of these but most are very difficult to trade) or an Australia wheat producer or a South African platinum miner all have a decent shot of capturing another seven years of commodity boom time even if the result is not the same as the commodities themselves.

The risk to the commodity ETPs is simple to see. I don't know whether anything bad will happen, I suspect not, but this is something I do not want to have to be correct about with client money on the line. A little exposure, yes, but a lot seems like a bad idea.

Congratulations to Jose Bautista of the Toronto Blue Jays who hit his 50th home run yesterday--I think Bautista's beard hit six of those home runs all by itself.