Investors Get Commodity Fever

Commodities have developed a reputation for providing a hedge against inflation and a low correlation to equities. Further research into this subject reveals that no such advantage exists. A study1 by former USC finance professor, Truman Clarke, details the lack of substantiation for the claims made by commodities proponents. A commodity is purchased with the hope that an increased demand or a decreased supply of the item will cause its price to increase. "Remember when you buy a commodity, you're not buying something that generates earnings and profit. You're buying a hard asset and hoping another buyer will be willing to pay more for that asset in the future," wrote Matt Krantz in a June 2008 USA Today article titled, "Read This Before You Jump on the Commodities Bandwagon."2

Commodity investments differ from stock investments in that the companies in the S&P 500 Index have earned profits that have produced an average return of about 9.8% per year for the last 86 years, ending December 2013. Their stock price is expected to increase in line with their growth in profits. The expectation of price appreciation for commodities is not based on profits, but rather on supply and demand. In short, commodities have not provided expected returns much greater than inflation.

Noted economist and professor of finance at Dartmouth, Kenneth French, conveyed his findings regarding commodities. He concluded, "The high volatility of commodity prices makes it impossible to accurately estimate the expected returns, volatilities and covariances of commodity funds, but theory suggests that if commodity returns are negatively correlated with the rest of the market, the expected risk premium on commodities is small, perhaps negative. Finally, commodity funds are poor inflation hedges. Most of the variation in commodity prices is unrelated to inflation. In fact, commodity indices are typically 10 to 15 times more volatile than inflation. As a result, investors who use commodity funds to hedge inflation almost certainly increase the risk of their portfolios."3

Step 11CommoditiesTruman ClarkeMatt KrantzKenneth French