Question about Commodities

Q&A with IFA: Commodities (2016 Update)

Question about Commodities

Question: Should I have a separate exposure to Commodities in my portfolio?

In short, we have concluded that the answer is no, and we will explain why below.

Based on returns data for the last 10, 20, 30, 40, and 46 years, the S&P GSCI Commodity Index severely under performed all the equity index asset classes across US, International and Emerging Markets. And adding insult to injury, the S&P GSCI Commodity Index has even underperformed the IFA Five Year Global Fixed Income over the same period on both an absolute and especially on a risk-adjusted basis.

 

 

 

 

 

If you are invested in a diversified portfolio of stocks like IFA’s Index Portfolio 100, you already have commodities exposure through energy, mining, agriculture and natural resource companies which make up about 8% of the portfolio.

The problem with commodities is that you are betting on what someone else would pay for them in six months. The commodity itself isn’t going to do anything for you….it is an entirely different game to buy a lump of something and hope that somebody else pays you more for that lump two years from now than it is to buy something that you expect to produce income for you over time.” 

Trading in commodities is pure speculation and not investing, and this is what Buffett had so humorously said about speculation in this interview featured on CNN Money.

 “At the beginning, it's driven by fundamentals, and then speculation takes over. As the old saying goes, what the wise man does in the beginning, fools do in the end. With any asset class that has a big move, first the fundamentals attract speculation, then the speculation becomes dominant. Once a price history develops, and people hear that their neighbor made a lot of money on something, that impulse takes over, and we're seeing that in commodities and housing...Orgies tend to be wildest toward the end. It's like being Cinderella at the ball. You know that at midnight everything's going to turn back to pumpkins & mice. But you look around and say, 'one more dance,' and so does everyone else. The party does get to be more fun -- and besides, there are no clocks on the wall. And then suddenly the clock strikes 12, and everything turns back to pumpkins and mice."

A recent working research paper by Marco Lombardi and Francesco Ravazzolo of the Bank for International Settlements monetary and economic department has debunked the myth that commodities provide a solid diversification for investment portfolios. John Kemp did an excellent job of summarizing it in this Reuters article. I found the following excerpt from the conclusion to be especially relevant:

“This paper has shown that the correlation between commodity and equity returns has substantially increased after the onset of the recent financial crisis…At the same time, an investment strategy, which also includes commodities in a portfolio, produces substantially higher volatility and not always produces higher Sharpe ratios [risk-adjusted returns]. This is at odds with the common notion that commodities serve as a hedge.”

Regarding gold and silver, they are commodities too, and we have addressed them here and here.

Since inception (1999), IFA has never recommended commodities to our clients and we have no regrets. We consider this stance to be consistent with our advice to “Invest but never Speculate.”

This reminds me of Jason Zweig’s article titled Saving Investors from Themselves in which he made the following astute observation:

“I was once asked, at a journalism conference, how I defined my job. I said: My job is to write the exact same thing between 50 and 100 times a year in such a way that neither my editors nor my readers will ever think I am repeating myself. That’s because good advice rarely changes, while markets change constantly. The temptation to pander is almost irresistible. And while people need good advice, what they want is advice that sounds good.”

 In our opinion, investing requires education, discipline and for most investors, the assistance of a fiduciary advisor. Our clients benefit from an unwavering commitment to strategies that incorporate financial innovations (or dimensions of expected returns) that are sensible, persistent through time, pervasive across markets and cost-effective to capture in a well-diversified portfolio.

IFA's recommendation is that investors establish an investment policy by taking the Risk Capacity Survey and a financial plan, then invest and relax. 

If you would like to learn more about our services, please call us at 888-643-3133.