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Why Investing in Commodities Can Be Challenging

Christine Benz

Christine Benz: Hi, I'm Christine Benz for In setting up model portfolios for I've piggybacked on some of the work being done in Morningstar Investment Management. Joining me to discuss some recent changes to asset allocation at Morningstar Lifetime Allocation Indexes is Brian Huckstep. He's a senior portfolio manager in Morningstar Investment Management.

Brian, thank you so much for being here.

Brian Huckstep: Thanks for having me.

Benz: I'd like to talk about the changes to the commodities exposure within the Morningstar Lifetime Allocation Indexes. Let's talk about why commodities were initially represented in the indexes and then more recently why you and the team decided to downplay them.

Huckstep: We think commodities make a great addition to multiasset portfolios. They're generally low-risk, have great correlation benefits--so, when markets are down, frequently they're up, and when they're up, frequently markets are down. So they make a great addition. However, when we build indexes, like the Lifetime Indexes, we have to use liquid versions of those commodities. We can't just buy gold or silver and put it in the closet or in the sock drawer and sit on it.

Benz: Well, that's true for most individual investors, too, right? Apart from very few commodities that are small and that you can in fact fit in your closet, most people need to turn to those liquid versions.

Huckstep: Yes. So, we're limited to using those in the models today, and the returns for liquid investments are a little bit different than the actual commodities. They're made up of three different components. They are made up of the spot price change. So, with a basket of commodities if energy goes up, the price of the commodity goes up and that's a positive return. They're made up of a collateral return. So, because those investments are typically done with futures, our portfolio manager will take the cash and invest it somewhere else because they don't need the cash when they buy the futures. So, we're going to some kind of safe bond typically.

And then the third source of return is roll yield. So, when you a buy a future on a commodity, the price will go up or down relative to that price. And today roll yield for commodities is negative for the majority of them and for the entire basket; it's been negative for quite a while--almost 10 years now we've seen negative roll yields. And so, typically, when you look back in history that roll yield has been positive and what that means is that investors have been paid to guarantee purchasing a commodity future in the future. And so, it used to be like a form of insurance. You used to get paid to provide that insurance. But today, there are a lot of people who have written about why this is the case, but it's clear that roll yields are negative. So, you pay for the right to buy that security in the future. It's almost like paying to provide insurance, and so that's not really attractive. And at a roughly an annual rate of 6% per year right now it's almost like an expense to these liquid investment funds, these liquid commodity funds. So any investment fund with a 6% expense per year is not necessarily that attractive to us.

Benz: So it's an enormous headwind, which is why you want to step away from commodities. I guess a risk, though, is that the price performance hasn't been there for energy commodities in particular. What if there is some sort of energy recovery and in hindsight, could you be making this change at what is an inopportune time?

Huckstep: Energy is a large component of a lot of commodity indexes. And so, it is the case that if energy prices go up from roughly $45 today up to $55, get a 10% or 20% bump, that will create a positive return for commodities and that would be terrific. However, we think that it's unlikely we're going to see that large a jump. It's hard to predict that. We try to predict returns 10 years out and 20 years out and over an infinite time horizon. So, we have those three different time frames and we really focus on that 10-year horizon. And to overcome a 6% negative roll yield per year for the next 10 years would require a big jump in energy prices. So on the roll yield, it may turn back to positive, but for the next year we think we have a lot more ability to forecast that negative roll yield than we do energy prices, and we think that that negative 6% is very likely to happen for the next year. But predicting a positive 6% in energy prices to overcome that, that's a little tougher of a hurdle.

Benz: And kind of a speculative bet?

Huckstep: It is speculative, and we don't want to be hedge fund-like and tactical oriented in these indexes. So we stuck with commodities for a long time. We do have that long-term horizon and we kept waiting for roll yield to flip back to positive and it just hasn't. So because it's been negative for so long, we really have updated some of our expectations, and liquid commodity investments are just not as attractive as they used to be.

Benz: OK. Brian, thank you so much for being here to share your insights.

Huckstep: Thanks for having me.

Benz: Thanks for watching. I'm Christine Benz for