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A Fresh Look at Commodities

An investment in commodities can offer some benefits, but they may be overhyped.  

Alex Bryan, 07/03/2013

Investing in commodities can be a little intimidating. They are frequently touted for their attractive long-term returns, diversification benefits, and as a hedge against both inflation and a decline in the value of the dollar. But in light of commodities' poor recent performance, and seemingly high correlation with stocks, it is worth re-evaluating each of these arguments in turn.

It can be difficult to understand how a piece of metal or stash of corn can offer investors a real return over the long run. After all, the immediate needs of producers and consumers determine commodity spot prices, rather than investors' return requirements. However, several researchers have argued that commodity futures contracts historically have compensated investors for offering price insurance to commodity producers (see Facts and Fantasies about Commodity Futures).

A futures contract is a standard exchange-traded agreement between two parties outlining the price and terms at which a future asset sale will take place. These contracts allow investors to gain exposure to commodities without holding the physical goods, which can be prohibitively expensive. Because no cash changes hands at the initiation of a futures contract, investors can place the notional principal in short-term T-bills, which can further enhance returns.

Commodity futures are not perfectly correlated with the underlying spot prices. In order to avoid taking physical ownership of the physical goods, an investor needs to sell each contract prior to expiration and replace it with one maturing further out. The new contract may have a higher price than the spot price on the date of the switch (this is called contango), which may cause the investor's performance to lag the spot commodity. This may happen if the costs of storing the commodity are high or if the market expects spot prices to increase over the life of the new contract.

Performance
The chart below illustrates the performance of three versions of the Dow Jones-UBS Commodity Index. The spot index approximates trends in commodity spot prices, ignoring storage costs, while the excess return index tracks the performance of the futures contracts after taking into account the net costs or benefits of rolling over the contracts (contango/backwardation). The total return version equals the excess return index plus any interest earned on short-term T-bills, assuming the contracts are fully collateralized. It offers the closest approximation of what a commodity futures investor could earn gross of fees.


Source: Morningstar.

From December 1990 through May 2013, the spot index gained 6.6% annualized. Of course, this is not an investable return. Storage costs and expected appreciation of spot prices eroded returns on the excess return index to 1.2% annualized, which is less than the pace of inflation. However, the total return index posted a 4.4% annualized return. In other words, most of the return on an investment in commodities futures contracts came from interest on T-bills, rather than from capital appreciation on the underlying contracts. This is hardly compelling compensation to justify equitylike risk.

However, these results are sensitive to the commodities included in the index and the weighting approach. The Dow Jones-UBS Commodity Index uses a combination of liquidity and production data to weight each commodity contract. I constructed an equally weighted total return index, representing a broad basket of energy, agricultural, and metals commodities, which returned 11.7% over the same period as described above. Equal-weighting is an active contrarian strategy that may enhance returns over the long term. Incidentally, GreenHaven Continuous Commodity Index GCC (0.85% expense ratio) offers such a strategy.  

Alex Bryan is an ETF analyst with Morningstar.

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