The rise and fall of commodities as a diversification tool for the masses may have been quick. Just two decades ago, only a select few investors viewed commodities as an asset class. Then came academic research into the returns of commodity futures that argued persuasively for their diversification qualities, and over the past 10 years, new indices opened the category to scores of individual investors for the first time.
This movement only recently surrendered some ground, thanks to the crisis of 2008, when commodity futures crashed along with every other asset class. While it is well known that the correlation of returns to historically uncorrelated assets goes to one amid a deleveraging crisis, the rising interest in commodity investing itself appears to be diminishing the asset class' viability as a portfolio diversifier. (View the related graphic here.)
Nature of Commodities
Certain characteristics about commodities will never change. First and foremost, commodities are non-earning assets; they do not produce any wealth of their own, so long-term prices will correlate closely to the marginal cost of production.
Many speculate that rising global demand and increasingly scarce resources will lead to high returns for commodity investments because of price increases. This may or may not prove true, but what is often overlooked is that price return will come without the benefit of interest income or dividends that traditional investments in equities and bonds provide.
In the short term, commodity price volatility will reflect the availability of above-ground supplies and the flexibility of producers to increase or decrease production relative to demand. Except for the unique case of precious metals, commodity inventories are typically scant compared with annual production, and resource producers have difficulty adjusting production in a meaningful capacity. That's the nature of commodities, and it leads to volatile returns.
Pool Grows Larger
Almost as certain as the characteristics of commodities spot markets will not change, it looks like the practice of investing in commodities futures has changed permanently.
The advent of commodity exchange-traded funds expanded financial investment in commodities from the few foundations and pensions that invested in the early futures indices to an enormous pool of individual and institutional investors worldwide. This influx had substantial consequences for the returns on those investments.
First, as investment dollars reach critical mass within any asset class, the asset class itself begins acting like other financial instruments. Its return profile becomes correlated to the capital markets cycle. In the not-too-distant past, portfolio managers and individuals used to trade mainly in equities and bonds. An entirely separate set of farmers, energy producers, and mercantile-exchange arbitragers dominated the commodities markets. Today, many more portfolio managers engage in commodity speculation, especially through the futures market, tying capital flows in commodities to those of the bond and equity markets. In fact, the monthly financial activity in the commodity space is considerably larger than the physical production, and that imbalance has grown rapidly over the past several years.
Second, most investors use futures to invest in commodities rather than owning the physical asset directly. Physical storage carries prohibitive costs for most commodities, forcing most financial investors to use futures and leaving the spot market prices to producers and major consumers. The futures investment strategy does have some flaws, however. As futures contracts near expiration, commodity funds have to roll those contracts to the next month's contract to avoid taking ownership of the physical commodity. The catch is that the futures curve--that is, the prices of contracts with progressively longer terms--can take an upward (known as "contango") or downward ("backwardation") slope. That slope can cause futures and spot returns to drastically differ over time.
The rub is that, over the past few years, most major commodity markets have been stuck in a persistent state of contango. Commodity future funds have had to sell contracts at low near-month prices and buy into costly further-month contracts, causing these funds to trail the returns of spot prices by an abnormally large degree. Before the major flood of financial investors in the past few years, this was not necessarily the case. Much of the positive return to commodity funds between 2000 and 2005 was because oil, typically the largest single holding of a commodity index, was mostly in backwardation during that period, resulting in positive returns from rolling into further-out contracts.
Government Suspicious
The question remains: Why has contango become so prevalent? The Commodities Futures Trading Commission has its suspicions--it is strictly enforcing position limits on all market participants. ETFs and mutual funds are being watched as closely as the traditional hedge fund speculator scapegoats.
My hypothesis is that the financial interest has grown too large relative to the physical market because of commodity index investors, and we now have excessive long-only demand that can only invest in futures contracts. This demand pushes up the prices of futures contracts relative to their expected value, leading to a state of persistent and extreme contango.
If the same investors who are buying futures today were instead buying physical commodities, we'd see spot prices skyrocket as limited supplies were hoarded and stored. Instead, because futures contracts are habitually sold before expiration and the proceeds invested in the next contract, we witness futures prices that perpetually exceed the combined spot price and cost of carry.
Basic economics would tell us that arbitragers should step in to store the physical commodity and take the short side of the futures prices. Storage facilities are of limited supply, however, and many of their rates are capped by government regulation. Hence, we've witnessed oddities like oil tankers, normally used for shipment, sitting idle in ports to act as storage facilities. Once financial investment outstrips the available inventories and storage capacity, arbitragers can no longer perfectly hedge out short positions in the futures contracts, allowing long-only pressures to take over and push prices above what the market fundamentals would predict.
Effect of Market Size
Of course, the data available is incomplete at best because we only have position estimates from the Commodities Futures Trading Commission, and these estimates do not include over-the-counter contracts such as swaps. But the data that is available indicates that negative performance of funds is highly correlated with the size of the market. For example, the total open interest in crude oil contracts has doubled since 2005 and more than tripled since 2002.
Short of a sharp increase in commodity prices, it is increasingly difficult for investors using a passive asset-allocation strategy to benefit from commodity funds today. Whether or not this situation will persist is debatable, but the opportunity may not present itself until a significant portion of investors retreat from the asset class.
Paul Justice, CFA, a contributing editor to Morningstar Advisor, is an ETF strategist with Morningstar.
