HardAssetsInvestor

Written by Lara Crigger  |

September 25, 2009

Larry Swedroe: The Case For Commodities

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The author of ‘The Only Guide to Alternative Investments You'll Ever Need' explains why investors should consider adding commodities to their portfolios.

• Parsing correlations
• Commodities as flood insurance
• Commodities stocks vs. futures

 

With all the talk of ETF closures and increased regulation, it's clear we live in the middle of a proverbial Chinese punch line: interesting times. Last week, guest Rick Ferri urged investors to approach commodities with great caution. This week, we caught up with Larry Swedroe to get a competing opinion.

Mr. Swedroe is principal and director of Research at BAM Advisor Services, and a principal and director of Research for the Buckingham Family of Financial Services. He's also a prolific author, and one of the most respected financial advisers in the business today. His latest book, The Only Guide To Alternative Investments You'll Ever Need, was published by Bloomberg last November.

This past week, HAI Associate Editor Lara Crigger chatted with Mr. Swedroe about the role commodities can play in an investor's portfolio, including how they correlate to stocks and bonds, why they act as "flood insurance" and whether investors should select commodity stocks or futures.

 

Lara Crigger, associate editor, HardAssetsInvestor.com (Crigger): During the Great Commodities Debate, you brought up the fact that commodities have a negative correlation to stocks and bonds, even during the times of their worst performance. But in the latter half of 2008, we saw all assets - including commodities - move together. Does this mean that commodities' traditional relationship to stocks and bonds no longer holds?

Larry Swedroe, BAM Advisor Services, Buckingham Family of Financial Services (Swedroe): Anyone who says that simply doesn't know the definition of negative correlation. What it means is that when one asset class has above-average returns, the other asset class tends to produce below-average returns, and vice versa. If the negative correlation were -1, then when one has above-average returns, the other always has below-average returns. The closer to 1 it is, the stronger the tendency; the closer it is to 0, the weaker the tendency.

People are told this story that commodities always go up when stocks are down, but they should take the time to look at the historical evidence. There's a table in my book that shows that since 1970, there were eight years of negative stock returns. During that time period, stocks returned an average of -12.5%. Some years were worse than others: In 1974, they were down 26.5%, and in 1990, they lost 3.2%.

In 1981, when stocks were down 4.9%, the GSCI was down 23%. Also, in 2001, when the S&P was down 11.9%, the GSCI was down 31.9%. Not only did commodities do poorly like stocks, they actually did worse than stocks. So anybody who makes the statement that people were unaware of this simply didn't take the time to look at the history.

Crigger: So when you're thinking correlation, you really do have to look at more than just the short-term picture.

Swedroe: Not only look at the correlation, but you also have to look at when they tend to turn high and low. Commodities have historically been negatively correlated with stocks and positively correlated with inflation. Commodities tend to do well when inflation is rising, even when it's low, and they tend to do poorly when inflation is falling, even if it's still high. So if you go from 12% inflation to 4%, you'll see commodities do poorly; but if you go from 0% inflation to 4%, you'll see commodities do well.

This is a classic error: You do not look at any asset class in isolation, whether for risk or for return. The only right way to look at an asset class is how its addition impacts the risk and return of the entire portfolio. That's what Markowitz won a Nobel Prize for 50 years ago.

Commodities provide a hedge or insurance against supply shocks. If you had disruptions to the supply - oil embargoes like we had in the ‘70s, or if Iran blocks the Strait of Hormuz, hurricanes, wars - they can protect against that.