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Investing in Commodity Futures: Oct 25, 2012

John Gorlow | Oct 25, 2012

Are Commodity Investments Right For You?

Investments into commodity-linked products have grown in recent years due to investors embracing alternative investments as a way to deal with inflation uncertainty in their portfolios.

Proponents claim that: 1) commodity futures produce average annual returns comparable to equities, 2) that commodity futures can lessen volatility of all stock and stock/bond portfolios because of their low correlation with stocks and bonds and 3) that commodity futures beat stocks and bonds as effective inflation hedges. If commodity futures increase returns, reduce risk, and provide inflation protection, who wouldn’t want to own them?

The prevalent view within the investment community is that futures positions generate systematic return for providing risk-transfer services to hedgers. Respected companies such as the Vanguard Group, present investments in commodity index funds as potentially valuable alternatives to augment traditional portfolio returns. However, despite academic and industry endorsements the recent performance of commodity index investments has been disappointing.

For example, consider the iShares S&P GSCI Commodity Index Trust. The GSCI is an Exchange-traded fund (ETF) designed to mimic the performance of the S&P-GSCI, one of the most widely followed commodity indices. The GSCI is a world production weighted combination of long positions in a group of nearby commodity futures contracts. The ETF was initially offered to the public in July of 2006 at a price near $50 per share. Since then, the share price has generally declined and is currently trading around $32 per share for a total loss of 37% over 5 years. Notably, these negative returns occurred over a period of time when there was a general upward trend in overall commodity prices.

The total return for an index investment utilizing commodity futures is composed of returns on the underlying commodity contracts complimented with returns on a fixed income component minus expenses. What explains GSCI’s poor performance? Return on the underlying commodity contracts has been negative and return on the fixed income is down, a function of systematically declining interest rates.

Data on commodity futures returns going back to the 1960s suggests that because the variability of commodity futures is high, it’s difficult to determine whether returns on commodity futures are different from zero. Unlike investments in equities or real estate, commodity futures markets produce no actual earnings; they are simply side bets on prices, not capital assets. And even though the GSCI is correlated negatively with stocks and bonds, combining futures with stocks and bonds may yield only small reductions in portfolio standard deviations. Additionally, even though the GSCI is correlated positively with inflation, the addition of futures to conventional portfolios may yield only negligible reductions in the standard deviations of real returns.

In constructing a portfolio, preservation of purchasing power is one of the primary goals for investors. Because inflation has the potential to erode the value of wealth, it is natural for investors to want to understand how to deal with it. Including commodity futures in a portfolio is not necessarily a bad idea across the board. Because, it is possible that commodity futures may serve as inflation hedges for stock and bond portfolios during periods of accelerating inflation. But introducing commodities into portfolios to hedge inflation may also add a lot of additional volatility that is un-related to inflation. Overall, the case for investment in commodities may not be as strong as implied in some studies.

Bottom line, investors seeking to manage their exposure to inflation risk should first consider alternatives to conventional longer-term bonds. Short-term fixed securities and Treasury Inflation Protected Securities (TIPS) are likely to be superior to commodity futures as long-term inflation hedging instruments.

Finally, the tax rates applicable to futures trading are high. Because of high turnover in commodity index funds and high tax rates applicable to futures trading gains, commodity futures make most sense for tax exempt or tax deferred investors.


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