The Case Against Commodities

02/25/2010 12:00 pm EST


Paul Justice

Associate Director of North American ETF Research, Morningstar, Inc.

Paul Justice, ETF strategist for Morningstar, says commodities may have become too popular and may not offer the diversification benefits they used to.

Only a select few investors viewed commodities as an asset class just two decades ago. However, the diversification argument in favor of commodities gained strength thanks to initial academic research into commodity futures returns and new indexes, which opened the category to financial investors for the first time.

This movement only recently surrendered some ground, thanks to the crisis of 2008 when commodity futures crashed along with every other asset class. [But] the rising interest in commodity investing itself may be diminishing the asset class’s viability as a portfolio diversifier.

Commodities are nonearning assets; they do not produce any wealth of their own, so longer-term prices will correlate closely to the marginal cost of production. Many speculate that rising global demand and increasingly scarce resources will lead to high returns for commodity investments due to price increases. But that price return will come without the benefit of interest income or dividends that traditional investments in equities and bonds provide.

[Also,] the advent of commodity exchange traded funds (ETFs) 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, with substantial consequences.

As investment dollars reach critical mass within any asset class, the asset class itself begins acting like other financial instruments: Its return profile becomes correlated to the capital markets cycle.

Today, many more portfolio managers engage in commodity speculation, especially through the futures market, tying capital flows in commodities to those of the bond and equity markets. In fact, the monthly financial activity in the commodity space is considerably larger than the physical production, and that imbalance has grown rapidly over the past several years.

If the same investors who are buying futures today were instead buying physical commodities, we’d see spot prices skyrocket as limited supplies were hoarded and stored. Instead, because futures contracts are habitually sold prior to expiration and the proceeds invested in the next contract, we witness futures prices that perpetually exceed the combined spot price and cost of carry.

Once financial investment outstrips the available inventories and storage capacity, arbitrageurs 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.

Of course, available data are incomplete at best, because we have position estimates only from the Commodities Futures Trading Commission (CFTC), which do not include over-the-counter contracts such as swaps.

But the data that are available indicate that negative performance of funds is highly correlated with the size of the market. For instance, the total open interest in crude oil contracts has doubled since 2005 and more than tripled since 2002.

So, short of a sharp increase in commodity prices, it is increasingly difficult for investors using a passive asset-allocation strategy to benefit from commodity funds today. Whether this situation will persist is debatable, but the opportunity may not present itself until a significant portion of investors retreat from the asset class.

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