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HardAssetsInvestor (HAI): Welcome, gentlemen. There's an ongoing debate among financial advisors about the usefulness of commodities in a long-term asset allocation. Most of the debate centers on returns. Can commodities, like equities, be reasonably expected to offer a return for a portfolio?
Rick Ferri: Physical commodities, of course, are uninvestable unless you own oil storage tanks and grain bins.
Research published by Erb and Harvey in "The Tactical and Strategic Value of Commodity Futures" indicates that commodities futures' real expected return-that is, the return net of inflation-is actually zero.
Erb and Harvey show that trading strategy is the sole source of returns in commodity futures indexes. In other words, it's the way an index provider constructs and rebalances an index that hypothetically created real returns in the past. Unlike stocks and bonds, simply buying and holding a diversified basket of futures contracts does not create real returns.
Larry Swedroe: It's true that commodities themselves have no expected real return. That's a pretty good reason to avoid investing in them. However, collateralized commodity futures, or CCFs, are another story.
The PIMCO Commodity Real Return Strategy fund, as an example, has total costs of about 1%. The portfolio managers use Treasury Inflation-Protected Securities (TIPS) as collateral to support the embedded commodity index derivatives. The real return on TIPS is about 2%, so the PIMCO fund provides a return, net of costs and inflation, of about 1%. That's above the real historic return of the benchmark one-month T-bill. Unless one forecasts persistent contango, where futures trade higher than the spot market, one should expect a real return from the PIMCO fund.
Rick Ferri: PIMCO's use of TIPS may boost returns, but that has nothing to do with commodities. PIMCO's capitalizing upon the spread between T-Bills and TIPS. Since the T-Bill yield is imbedded in commodity futures prices, PIMCO is essentially shorting T-bills and buying TIPS. That's interest rate arbitrage, not commodity investing.
HAI: Financial advisors often point to correlation - or more properly, noncorrelation - as a reason to include a commodities allocation in a portfolio. Where do you stand on the correlation issue? Would negative correlations alone be reason enough for an allocation?
Swedroe: Futures, or more specifically, CCFs, are one of the rare asset classes that have negative correlation to both stocks and bonds. That makes them excellent risk diversifiers. A negative correlating asset acts just like portfolio insurance because it tends to produce higher-than-average returns when the other asset is producing lower-than-average returns.
In each of the nine years since 1970 that long-term bonds produced negative returns, CCFs produced positive returns. The average is about 30%. And, in the eight years of negative stock returns, since then, CCFs produced positive returns six times, garnering an average gain of 23% for all eight years.
The negative correlation is easily explained and quite logical. CCFs are positively correlated to unexpected inflation while stocks and bonds are negatively correlated. Hence the very strong performance against bonds. But CCFs also provide a hedge against event risks. Some event risks such as the oil crisis of the ‘70s impact stocks and commodities differently. Others, notably 9/11, cause the markets to react similarly. Put simply, if an event creates inflationary-type recession, then it is good for CCFs but bad for stocks. If an event creates a deflationary environment, than you'll see the correlation of stocks and CCFs rise.
Negative correlation is not enough reason for making an investment. One should also consider the return. But the mistake so many people make is considering return in isolation. The question really centers on the impact of adding the commodity return on the overall portfolio. Harry Markowitz basically won a Nobel Prize dealing with this issue. He showed that adding risky assets can actually increase returns without increasing risk, depending on volatility and correlations.
With negative correlation we actually like higher volatility because, with rebalancing, the diversification return increases. You buy at lower lows and sell at higher highs. Economic theory states that assets with negative correlation should have less than the riskless return because they act like insurance.
Who do you think won the Great Commodities Debate? Vote here
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