Why commodities belong in a portfolio

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31 Oct 2010

Inside a London conference hall earlier this month, about 300 investment professionals grappled with the topic of commodity investing. Much of the discussion was technical, but there were some plain-English nuggets worth sharing.

Rather than recount individual conference sessions about how and why to use commodities, I have organized them by theme:
Inflation hedge. The “respectable” reason for investing in commodities is to “hedge against inflation.” But ever since crude oil shot up to $140 a barrel in 2008, performance has attracted billions of dollars to the asset class over the past two years, when inflation has not been an issue.
Still, if commodity prices rocket higher, inflation could be ignited in the not-distant future.
“Commodities are an imperfect hedge against inflation, but they are better than any other asset class,” said Geert Rouwenhorst, a Yale University finance professor and a principal in SummerHaven, whose index is the basis of a new exchange-traded fund, United States Commodity Index Fund (CONSOLIDATED:USCI) .
Indeed, the Dow Jones-UBS Commodity Index correlated as high as 75% with the Consumer Price Index (CPI) on a three-year rolling basis, though the average was 52%. By contrast, stocks had a negative correlation of 7.8% and bonds a negative 8.5%, meaning prices of those instruments tended to fall as inflation increased.
Bob Greer, executive vice president of Pimco, an asset-management firm, applied the so-called 80-20 rule to commodities and the CPI.
“Commodities account for about 20% of the prices of things in the CPI basket, but for about 80% of the volatility of the CPI,” he said.
Diversification. Commodities got bad reviews as a portfolio diversifier in the bear market of 2007-2009. Shockingly, their prices plunged right along with stocks, and aggrieved investors wondered where diversification was when they needed it.
Greer took issue with that view. “Diversification doesn’t mean commodities go up when stocks go down,” he asserted. “It means that the economic factors driving these markets are totally different.”
Sometimes, of course, those factors coincide. With the onset of recession in 2007, for example, demand for commodities (from energy to industrial metals to foodstuffs) contracted sharply as businesses and consumers battened down the hatches. The result was falling prices in both commodity and futures markets.
Nonetheless, Rouwenhorst noted that “commodities are an input to a productive process, while equities, through corporate profits, are a result of a productive process. This difference provides a natural diversification to a portfolio.”
Supply and demand. The current uplift in commodity prices generally are being driven by demand rather than supply, said Tim Crowe, CEO of Anchor Point Capital, a money-management firm. He added, “This condition also is conducive to higher equity prices, which means greater correlation” of the two markets.
There are two reasons for these demand-pull price gains that have pushed the DJ-UBS Commodity Index up 38% since March 2009. First, inflation-adjusted interest rates are negative, and probably will become more so if the Federal Reserve and other central banks ease monetary policy further to stimulate economic growth.
“Negative interest rates spur demand for commodities, but do nothing to increase supply,” said Francisco Blanch, head of global commodity research for Bank of America Merrill Lynch.
Moreover, Blanch said, “Commodities have relatively small amounts of spare capacity to boost supplies, unlike what is prevalent in, say, manufacturing.” Indeed, added Jeff Currie, head of global commodity research for Goldman Sachs, “there are significant supply constraints in crude oil, copper, corn and soybeans, and platinum.”
Several speakers predicted developing countries will increase demand for commodities over the next two to three years, especially China and India. Current growth rates in those countries far outstrip traditional “super consumers” such as the U.S., Europe and Japan.
Energy. “Oil will touch $100 a barrel next year, then retreat,” predicted Blanch. “For all of 2011 oil will average about $85 a barrel. Price swings will happen, but oil won’t hit new highs for two or more years.” 
Natural gas prices “will remain low for the next few years,” he added. The low prices “will increase demand, but it will have to overcome excess supplies” to move prices higher. However, “for the longer term the outlook is bullish,” he said.
Gold. Blanch foresees the price of gold reaching $1,500 an ounce. One source of upward price pressure is coming from the central banks of emerging markets, whose booming economies require gold purchases to stabilize their currencies. He estimates these central banks “need to buy 12,000 tons” of the precious metal.
However, Blanch and others warned that gold’s heyday will end abruptly whenever interest rates begin to climb. “There is a negative correlation between gold and real (inflation-adjusted) interest rates,” said Currie of Goldman Sachs. When those rates start rising, gold prices will fall fast.
Passive vs. active management. Many of the speakers manage money actively. Of course, they sang the praises of “flexible” and “opportunistic” active strategies over “fixed” and “predictable” index-based investment products. And of course they did not mention the fees they charge for this service, which people tell me are in the range of $20 for each $1,000 invested — with some taking an additional 20% of any profits, like a hedge fund.
My takeaway from this conference is that commodities ought to have a place in many if not most portfolios. The weight of this investment can be adjusted for risk tolerance, but anything less than 5% probably is not going to make much of a contribution. On the other hand, an allocation of more than 15% can move the entire portfolio to a higher risk level.
While not every commodity is poised to shoot up in price — natural gas and aluminum have bearish outlooks for the near term — enough of them are in high-demand-constricted-supply conditions to be attractive for the foreseeable future. But the ride will be rocky, as it always is in commodities.
As Crowe of Anchor Point put it: “I’m confident that if I put money into commodities today and went to sleep, I’d have more money when I woke up 10 years from now. But I’ll be glad I was asleep because of the extreme volatility over the course of that decade.” 

Source: Marketwatch