For Inflation Protection, Commodities Belong in the 'Too Hard' Pile

Investors are gravitating to commodities-tracking funds and exchange-traded funds: The group raked in $16 billion in the one-year period through May 2021, with $6 billion of that coming in the month of May alone. That one-year increase accounts for about a 10th of the total assets in the category.

It's easy to see the attraction. Commodities-tracking mutual funds, which typically use futures contracts to reflect the price of raw materials such as oil, metals, and agricultural products, have gained more than 50% on average over the past year, outperforming even red-hot U.S. stocks over that stretch.

Commodities also look like a lucrative place to be, given that demand for almost everything has been shooting up as the pandemic has receded. Consumer prices jumped 5% between May 2020 and May 2021, their biggest increase in any one-year period in 13 years. Commodities-tracking investments tend to be beneficiaries in inflationary environments, so investors often flock to them in periods when prices are running up.

Yet it's worth noting that investors have previously timed their purchases of commodities poorly, gravitating to the group after big performance runups and capitulating near the bottom. Can they avoid doing so during this cycle? I'm not hopeful, and that's why I'm much less positive on commodities for inflation protection than I am on Treasury Inflation-Protected Securities, which deliver inflation protection in a slower, more deliberate way.

Learning From History

The last time commodities caught fire was in the early and mid-2000s. Pimco launched its Commodity Real Return Strategy PCRAX in 2002, and Invesco DB Commodity Tracking DBC was the first ETF to enter the fray, in 2006. Underpinning all of the launches was academic research pointing to the attractions of commodities as a diversifier for conventional portfolios consisting of stocks and bonds. In a research paper first published in 2004, professors Gary Gorton and K. Geert Rouwenhorst concluded that over 45 years' worth of history, commodities futures had offered equitylike returns and risk. Even more enticing, their research showed that commodities futures demonstrated minimal correlation with stocks or bonds but were positively correlated with unexpected inflation.

You know what happened next. Investment firms flooded the market with commodities-tracking investments, mainly commodities futures funds and ETFs, and by 2010, there were 55 such funds. Assets in commodities funds jumped from $260 million in 2002 to $17.5 billion in 2007. Performance helped fuel investor interest, especially among investors who were scarred by the dot-com bust. The prices of most major commodity types surged in the mid-2000s, driven by demand from emerging markets. The Pimco fund, for example, gained 27% on an annualized basis in the three-year period between 2003 and 2005. Commodities prices flatlined in 2006 before soaring again in 2007.

As is so often the case, investors crowded into the group at an inopportune time. As the global financial crisis came into view in late 2007, commodities prices held steady for a bit, soaring that year even as stocks began to struggle and delivering on their diversification promise. But commodities prices fell sharply in 2008, leading most commodities funds to losses of 30% to 50% during that year. In the subsequent economic recovery that kicked off in 2009, commodities recovered but never fully regained their former glory. From the stock market's nadir in 2009 through mid-June 2021, commodities tracking funds underperformed bonds and lagged stocks by a mile.

Commodities' much-ballyhooed ability to diversify stocks and bonds has also declined. Their long-running slump prompted many investors in the funds to capitulate. Asset inflows into funds in the commodities broad basket Morningstar Category peaked in 2010 at $15 billion, but a series of outflows followed between 2013 and 2015. The group saw one of its largest single-year outflows in 2020, shedding an estimated $3.7 billion in assets. That means those investors weren't around to benefit from the group's stunning recovery so far in 2021.

A Troubling Mismatch

Will new investors in commodities funds fare any better? I'm not hopeful. A big issue with commodities is that unlike cash-flow-producing assets like stocks or bonds, it's impossible to figure out what they should be worth and whether there's any justification for their prices to go higher in the future. A bet on commodities-tracking investments is just that--a bet. You may get lucky and watch commodities prices soar after you purchase such an investment, or you could be like the 2007 commodities-fund buyers and quickly lose a third or even half your money. That seems like a particularly big risk factor today, given that it's unclear whether the inflation we're seeing today will be ephemeral or more persistent.

One response, of course, is to forget trying to catch the upward swing in the commodities price cycle. Instead, own commodities as a long-term, strategic inflation hedge and portfolio diversifier, holding them through thick and thin. That's easier said than done, thanks to commodities' volatility. The typical commodities-tracking fund has a standard deviation of 16 over the past decade, higher than equities. That volatility invites some of the investor-timing problems that we've seen since commodities came into vogue 15 years ago. There's also the separate issue of contango, which makes commodities futures and the funds that track them imperfect reflections of commodities prices at any given point in time.

To my mind, the biggest knock on commodities as a strategic inflation hedge, especially for retirees who are actively drawing upon their portfolios and want to maintain purchasing power, is that there's a mismatch between the hedge you need if you're worried about inflation and how commodities prices actually behave. In inflationary periods in the United States, rising prices take a small bite out of the purchasing power of investment assets year in and year out. Yet if you mistime your commodities investment purchase and buy at a high point in the cycle, you could lose a big share of your investment right out of the box. You're trying to offset the slow but steady corrosive effects of inflation with an investment type that's anything but slow and steady.

That's why I can't help but gravitate to TIPS or I Bonds as a better inflationary hedge, especially for people who are in drawdown/retirement mode. The price of your TIPS investment steps up with the Consumer Price Index, protecting you against unexpected jumps in inflation. TIPS will never gain 30% in a given year, but they're also very unlikely to lose that much. The investment product seems much better aligned with the risk that you're trying to defend against.