The article was published in the August issue of Morningstar ETFInvestor.
In part 1 of this article, we looked at the fundamental differences of commodities in the past and present. In part 2 of this article, we will try to reevaluate the case for commodities as a long-term investment.
Unintended (and Largely Unexpected) Consequences of ETF Democratization?
The advent of commodity exchange-traded products around the world expanded financial investment in commodities from the few foundations and pensions that invested in the early futures indexes to an enormous pool of individual and institutional investors worldwide. This may have turned Keynes’ theory of normal backwardation on its head, as speculators flooded the market in the mid-2000s, around the time that G&R published their influential research, and following a multiyear bull market for commodities (remember when China couldn’t get enough?).
In the not-too-distant past, portfolio managers and individuals used to deal mainly in equities and bonds. An entirely separate set of farmers, energy producers, and mercantile-exchange arbitragers dominated the commodities markets. By the mid-2000s, many more investors began to engage in commodity investment/speculation. In fact, during this period of exceptional growth, the monthly financial activity in the commodity space often considerably outweighed the value of physical production. It appears that this influx may have had significant implications for the returns on those investments.
Consider that at the end of 2005, there was less than US$5 billion invested in U.S.-listed commodity ETPs. About five years later, after a period of exponential growth, assets in commodity ETPs topped out around US$125 billion. By this time, investors started to learn about terms like contango and backwardation, realizing that they needed to adjust their expectations. Since topping out in August 2011, commodity ETP assets have been in decline thanks to negative returns and sharp redemptions. Investors have yanked more than US$22 billion out of commodity ETPs over this period.
Based on the available data, a reasonable hypothesis would be that financial interest grew too large relative to the physical market because of commodity index investors, creating excessive long-only demand that can only invest in futures contracts. This demand acts to push up the prices of futures contracts relative to their expected value, leading to a state of persistent and extreme contango.
If the same investors who were buying futures were instead buying physical commodities, we would have seen spot prices skyrocket as limited supplies were hoarded and stored. Instead, because futures contracts are habitually sold before expiration and the proceeds invested in the next contract, we witness futures prices that perpetually exceed the combined spot price and cost of carry.
Basic economics would tell us that arbitragers should step in to store the physical commodity and take the short side of the trade. Storage facilities are in limited supply, however, and many of their rates are capped by government regulation. Hence, we’ve witnessed oddities like oil tankers, normally used for shipment, sitting idle in ports to act as storage facilities. Once financial investment outstrips the available inventories and storage capacity, arbitragers can no longer perfectly hedge out short positions in the futures contracts, allowing long-only pressures to take over and push prices above what the market fundamentals would predict.
Adjusting Expectations
Given the meaningful shift that has occurred in the futures market for commodities in recent years, it may be a good idea to reevaluate the case for commodities as a long-term investment. It’s no secret that commodities have had a rough stretch over the past few years. Is there still a potential diversification benefit to adding commodity futures to a portfolio? Updated correlation data suggest that commodities may not be that useful as portfolio diversifiers. Along with the correlation figures presented by G&R, the first table below also shows correlations for the 10-year periods before and after the study was released.
To gauge portfolio impact, I’ve used a hypothetical 60/40 portfolio as a baseline, comparing it against similar portfolios that include a stake in commodity futures. The results speak for themselves: Over the past 15 years, an allocation to commodities has generally resulted in lower returns and greater risk.
Whereas G&R’s influential academic research was based on a period characterized by positive roll yields and high collateral returns, the situation today is much different. Roll yields have turned sharply negative in recent years, and collateral returns are basically nil thanks to near-zero interest rates. Further, rising correlations over the past several years have damped the potential diversification benefits. As a result, barring a return to a persistent state of "normal backwardation," commodity futures may not be as attractive an asset class as it was once thought to be.
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