Occam’s – Should Your Portfolio Include Commodities?

WHAT IS OCCAM’S RAZOR?
Occam’s Razor is a principle attributed to William Occam, a 14th century philosopher. He stressed that explanations must not be multiplied beyond what is necessary. Thus, Occam’s Razor is a term used to “shave off” or dismiss superfluous explanations for a given event. This concept is largely ignored within the investment management landscape. This newsletter will “shave off ” popular investment misinformation and present what is important for achieving long-term investment success.

Last month, a client received a rather large inheritance and was curious to know what else we could add to their investment portfolio that we may have been holding back on. They were somewhat surprised to hear that they were already well-represented across the global capital markets and we really didn’t want to do anything different. Getting into the investments past the velvet ropes just means you get to pay more in fees; it doesn’t do anything to help your portfolio.

You should want your investments to move slowly and steadily toward your goals, but everyone is human. We’re all attracted by the shiny new thing that promises huge rewards. We are also attracted to what other people may have in their portfolio, especially if we deem their solution to be more “sophisticated” or previously beyond our reach. When it comes to investing, a whole bunch of magical investment solutions seem to be floating around out there.

Most of these “solutions” rely on trying to predict what will happen next. We’ve talked a lot about the failure of active management, so we can put such solutions to the side.

I want to focus on one area clients frequently ask about: commodities. Commodities are often viewed as, if not a more sophisticated solution, a good way to goose your portfolio. However, that is not the case. Commodities do not help long-term investors meet goals.

The Problem with Commodities

We always seem to hear about commodities when they have done really well, which is no different than anything else in finance. Commodities differ from a lot of other strategies you hear about in one important way: they are, as their name indicates, commodities, which means they are standardized, interchangeable goods.

A barrel of West Texas Intermediate crude oil is exactly the same as any other barrel of West Texas Intermediate crude oil. An ounce of gold is the same as any other ounce of gold. Standardization lets the commodities markets operate effectively. Everyone knows exactly what is being bought and sold.

But commodities are just things. They don’t produce any value in and of themselves. They’re valuable, but they don’t create new economic activity. In short, they don’t increase the size of the pie. Buying a commodity is fundamentally different than investing in a company. Companies are going concerns. The whole point of a company is that it creates economic value (or at least it’s trying to). Companies want to increase the size of the pie.

In practical terms, this means that the long-term expected return of commodities is inflation. Commodities are basically moving along with inflation—at least over the long term. What makes people get so excited about commodities every once in a while is their massive volatility. If we look at the data, that volatility becomes immediately obvious:

Inflation and Commodity Data from 2/91-4/16

Annualized Return Annualized Standard Deviation Growth of $1
Bloomberg Commodity Total Return Index 2.40% 14.92% $1.82
S&P 500 Index (General stock market index) 9.61% 14.45% $10.13
US Consumer Price Index (Inflation) 2.30% 1.16% $1.78

Data provided by Dimensional Fund Advisors.

The long-term returns are essentially equivalent to inflation, and the standard deviation is actually greater than the S&P 500 Index. But you could say that since commodities move differently than stocks, they are still a benefit to the portfolio even if their risk/return profile doesn’t look so good in isolation. That rationalization, however, doesn’t fly either.

An easy way to look at the benefit (or lack thereof) of commodities to a portfolio is to run the correlations between the different asset classes. A low correlation means the two asset classes don’t move together. There’s a bit of math involved, but the lower the correlation between two investments, the lower your portfolio standard deviation is going to be, all else being equal. In other words, low correlations are good for your portfolio.

In this example, I’ve substituted One Month US Treasury Bills for the US Consumer Price Index. You can easily invest in one-month treasury bills, while it’s hard to really invest in inflation. In fact, you’re basically investing in one-month treasury bills (or things pretty close to them) when you open a savings account at your bank, though the bank also takes their cut. One other note about One Month US Treasury Bills: over the same period, they had higher returns (3.50%) and lower standard deviation (0.95%) than both the Bloomberg Commodity Total Return Index, and the US CPI.

Correlation Table from 2/91-4/16

Bloomberg Commodity Total Return Index 1.000
S&P 500 Index 0.302 1.000
One Month US Treasury Bills 0.097 0.045 1.000
Bloomberg Commodity Total Return Index S&P 500 Index One Month US Treasury Bills

Data provided by Dimensional Fund Advisors.

While commodities have a relatively low correlation with the S&P 500 Index, One Month T-Bills have a much lower correlation to equities. The correlation difference means that investing in the T-Bills not only results in a higher return and lower standard deviation by itself, it will also be much better for your total portfolio.

In fact, pretty much any way you want to slice it, commodities do not make sense for long-term investors.

If we look at commodities’ best and worst rolling returns, the highs are lower, and the lows are lower than those of the S&P 500.

Best and Worst Rolling Return Period 2/91 – 4/16

Best Rolling Return Period 1 Year 3 Years 5 Years 10 Years
Bloomberg Commodity Total Return Index 41.56%

(7/07-6/08)

21.83%

(3/02-2/05)

18.60%

(7/03-6/08)

13.01%

(7/98-6/08)

S&P 500 Index 53.62%

(3/09-2/10)

32.81%

(4/95-3/98)

28.56%

(1/95-12/99)

17.37%

(2/91-1/01)

 

Worst Rolling Return Period 1 Year 3 Years 5 Years 10 Years
Bloomberg Commodity Total Return Index -50.27%

(3/08-2/09)

-18.41%

(2/13-1/16)

-14.44%

(3/11-2/16)

-6.76%

(2/06-1/16)

S&P 500 Index -43.32%

(3/08-2/09)

-16.09%

(4/00-3/03)

-6.63%

(3/04-2/09)

-3.43%

(3/99-2/09)

Data from 2/91 – 4/16. Data provided by Dimensional Fund Advisors.

If we look at the distribution of their monthly returns, we see a similar story. In the 303 months from February 1991 to April 2016, the Bloomberg Commodity Total Return Index was down 43% of the time, and the S&P 500 was down only 35% of the time. For comparison, the One Month US Treasury Bills only had a negative return 2.6% of the time (that’s only eight months over the past twenty-five years).

Looking at the total distribution, both the S&P 500 Index and the Bloomberg Commodity Index had roughly two-thirds of their monthly returns between -4% and 4%. But the commodities were skewed left. In other words, commodities had more bad months and fewer good months.

Should Your Portfolio Include Commodities?We could keep going, but I think the data is pretty clear: commodities have significantly lower returns over time than equities (as well as One Month US Treasury Bills), but even higher volatility than equities. As I said before, this volatility is why people get excited about them every now and then. Since commodities only have a moderate correlation with equities, sometimes commodities will have a good run when equities are not doing so well, but this is just random chance.

What Are Commodities?

Commodities are just things; they are valuable largely insofar as they are inputs for companies to use to make other things. Commodity prices will go up as the price of the things they are used to produce goes up. And, to a first approximation, this means commodity prices will go up with the growth of the economy and inflation.

When we talk about something as broad as commodities, we’re talking about a pretty massive swath of the economy. The term “commodities” encompasses everything from gold, to pork bellies, to crude oil, to cotton. But when most people talk about investing in commodities, they aren’t talking about investing in cotton or palm oil. They’re pretty much exclusively talking about investing in gold (and other precious metals) or crude oil. So let’s take a look at those specifically.

Gold

As Warren Buffet said, “[t]he 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.”

He goes on to talk about gold specifically: “[I]f you took all the gold in the world, it would roughly make a cube 67 feet on a side…Now for that same cube of gold, it would be worth at today’s market prices about $7 trillion dollars—that’s probably about a third of the value of all the stocks in the United States…For $7 trillion dollars…you could have all the farmland in the United States, you could have about seven Exxon Mobils, and you could have a trillion dollars of walking-around money…And if you offered me the choice of looking at some 67 foot cube of gold and looking at it all day, and you know me touching it and fondling it occasionally…Call me crazy, but I’ll take the farmland and the Exxon Mobils.”

As impressive as a seventy-foot cube of gold would be, we should look at the historical returns to make sure the logic for commodities as a whole also holds true for gold. People hold up gold as special because gold has been used as a store of value almost since we first found it lying on the ground.

Often the most vociferous of the gold bugs will talk about how gold is even more “real” than actual currency. If this is the case—if gold is a store of value as well as a lump of metal—then we would expect to see the price of gold go up faster than inflation. And to the extent that gold is a better store of value than currency, we would expect to see it do exceptionally well during periods of high inflation.

However, we don’t see either of those scenarios play out. Over the long term, gold underperforms one-month treasury bills, again with greater volatility than the S&P 500 Index.

Data from 1/1980 – 4/16

Annualized Return Annualized Standard Deviation Growth of $1
Gold Spot Price 2.39% 18.32% $2.36
S&P 500 Index (General stock market index) 11.47% 15.13% $51.62
US Consumer Price Index (Inflation) 3.18% 1.23% $3.12

Data for the S&P 500 Index and US Consumer Price Index provided by Dimensional Fund Advisors. Gold Spot Price computed from data provided by the Federal Reserve Bank of St. Louis[1].

Just like commodities as a whole, gold has significantly outperformed the markets many times, but over the long term it hasn’t been able to keep up with inflation.

Even if gold may not provide great returns by itself, it’s often held out as a great inflation hedge (we’ll ignore the fact that you can hedge against inflation extremely effectively with TIPS and short-term fixed income). If this is true, then gold may be worth owning to protect against inflation.

I think you can guess where this is going.

Gold is not an effective hedge against inflation. A quick check would be to look at what happened in the 1980s—the era of double digit mortgage rates.

Data from 1/1980 – 12/89

Annualized Return Annualized Standard Deviation Growth of $1
Gold Spot Price -2.64% 23.17% $0.77
S&P 500 Index (General stock market index) 17.55% 16.41% $5.04
US Consumer Price Index (Inflation) 5.10% 1.22% $1.64

Data for the S&P 500 Index and US Consumer Price Index provided by Dimensional Fund Advisors. Gold Spot Price computed from data provided by the Federal Reserve Bank of St. Louis

Gold did not act as a good store of value in the 1980s. If gold was going to hedge against inflation, then we should see high returns for gold when there is high inflation. We didn’t see that during the 1980s. But gold is incredibly volatile, so it could just be random chance that the 1980s was a bad period overall[2].

For further proof, let’s break this down on an annual basis. Over the period 1980–2015, there were seven years where inflation was greater than 4%. Of those seven years, gold outperformed inflation only once—in 1987. Just to be sure, let’s do a little sensitivity analysis on this.

Annual Returns from 1980 – 2015

Years Inflation Greater Than Number of Years Gold Outperformed Inflation When Inflation Greater Than % of Time Gold Outperformed Inflation When Inflation Greater Than
3% 16 6 37.5%
3.5% 11 4 36.4%
4% 7 2 28.6%
4.5% 4 0 0.0%

Inflation represented by US Consumer Price Index. US CPI data provided by Dimensional Fund Advisors. Gold Spot Price computed from data provided by the Federal Reserve Bank of St. Louis.

The annual returns from 1980 to 2015 show us that gold is actually less likely to outperform inflation as annual inflation increases. Over the short term, gold is not a good inflation hedge. It acts just like any other commodity in that it reacts to supply and demand, which looks pretty similar to the broad economy over long periods of time. It’s a lump of metal.

Oil

But what about oil? Oil drives our economy. Without it, everything would grind to a halt (literally in a lot of cases). It’s a diminishing resource, and to top it off, a lot of oil comes from areas of the world that are not particularly stable. There’s got to be something to work with here, right?

Not so much. It turns out that the price of a barrel of oil hasn’t gone up much since 1980[3].

Data from 1/1980 – 04/16

Annualized Return Annualized Standard Deviation Growth of $1
Global Price of Oil 0.65% 28.29% $1.27
S&P 500 Index (General stock market index) 11.47% 15.13% $51.62
US Consumer Price Index (Inflation) 3.18% 1.23% $3.12

Data for the S&P 500 Index and US Consumer Price Index provided by Dimensional Fund Advisors. Oil returns computed from data provided by the Federal Reserve Bank of St. Louis[4].

Oil has done significantly worse than other commodities we have looked at. That may be surprising at first glance, but when you stop and think about what’s going on here, it makes a lot of sense. This is supply and demand in action. We’ve gotten really good at getting oil out of the ground, and we’ve also started to proactively look for ways to reduce our use of oil as a society. In other words, as technology improves, supply goes up and demand (or at least the rate of increase in demand) goes down. This is Economics 101.

The price of oil is massively volatile. Just look at the last ten years of annual returns:

Annual Return of Oil Annual Return of S&P 500 Index
2006 -17.17% 15.80%
2007 71.42% 5.49%
2008 -55.11% -37.00%
2009 87.69% 26.46%
2010 14.26% 15.06%
2011 11.89% 2.11%
2012 -5.49% 16.00%
2013 0.36% 32.39%
2014 -49.89% 13.69%
2015 -33.40% 1.38%

Oil returns computed from data provided by the Federal Reserve Bank of St. Louis. Data for the S&P 500 Index provided by Dimensional Fund Advisors.

Over the last ten years, we’ve seen some pretty big moves from both oil and the stock market, but oil bounced around a lot more. To give some perspective on just how much more volatile oil has been than the stock market, let’s look compare standard deviations:

Data from 2006-2015

Standard Deviation Sum of Absolute Value of Annual Returns
Global Price of Oil 47.19% 346.67%
S&P 500 Index 18.97% 165.39%
Oil / Stock Market 2.49 2.10

Oil returns computed from data provided by the Federal Reserve Bank of St. Louis. Data for the S&P 500 Index provided by Dimensional Fund Advisors.

For comparison, the standard deviation of the annual returns of the US CPI over the same period was 1.21%. Oil was roughly thirty-nine times more volatile than inflation, even though oil’s long-term annualized return is about one-fifth of the long term annualized return of inflation.

When traders see so much volatility, they instinctively want to be long oil during the up years and short oil during the down years. If they could do it, they could have some absolutely massive returns.

Even if we grant that it’s possible to predict what the market is going to do in the future (which it isn’t) or at least that someone could do it better than chance (which they can’t), in order to successfully time the market you have to be right twice. You have to be able to predict both when to get it in and when to get out. But think about getting it wrong one year.

Look at the period from 2007–2009. The smallest move over those three years was -55 percent. Trying to time anything nearly as volatile as oil (or any other commodity) is a monumental task. If you want to try your hand at it, have fun, but I think there’s an African prince who would like your help getting their fortune out of the country that would like to talk with you first…

One other thing to consider when you’re looking at commodities as an investment is that the economy as a whole is basically net neutral on them. You have a (relatively) small number of companies that produce and sell commodities, and then a whole bunch of companies (pretty much everyone else) that buy them. If you own a globally diversified portfolio, your portfolio will mirror this situation.

In April 2016, a little more than 11% of the world market was made up of companies that produce commodities.[5] The value of these companies is obviously tightly tied to the price of whatever commodity (or commodities) they produce or work with. When the price of commodities goes up, these companies do well. The other 89% of the market, at least to a first approximation, goes the other way. When the price of commodities goes down, the rest of the economy does slightly better.

So the question is really if you should choose to tilt your portfolio toward commodity risk like we do with risks such as size or value that have proven to have positive long-term expected returns.

As we’ve seen above, the answer to that question is pretty clearly “No, you don’t want to tilt your portfolio toward commodities.” They have lower long-term returns than extremely short term, high quality bonds, but have higher than equity volatility. At least with fixed income you are reducing the risk in your portfolio. Overweighting commodities just gives your portfolio lower expected returns and increased volatility.

The next logical question is this: Should we invest in companies focused on producing commodities?

Yes, we should. First off, they are a part of the world economy, and to be fully diversified we want them in the portfolio. We don’t necessarily want to overweight them, but they do represent a substantial portion of the world market, so they should be in the portfolio. But even within the framework we’ve been talking about, a company producing a commodity is different than the commodity itself.

A commodity is just a lump of something. A company is a living organization that is responding to events and trying to make as much money as possible. That means they are making production decisions about how much to produce and how to do so, looking at new opportunities, and generally doing everything they can to increase the size of the pie.

It’s important to recognize that this logic is not just limited to commodities. It relates to anything that does not produce economic returns in and of itself. Commodities are the most common “investment” that is really just a trading vehicle, but there are others out there (i.e. currencies, fine wine, art, etc.).

Any time something does not produce any economic value itself, then it most likely is not something we want to include in a portfolio, especially considering that a broadly diversified global portfolio almost assuredly already has exposure to whatever hot new investment you’re considering.

When we build a portfolio, we have to think about a whole bunch of factors. There are the obvious ones like maximizing returns and minimizing risk, but we also need to think about other risks such as inflation.

When we break everything down, commodities don’t help us with any of the competing factors we look at during portfolio construction. They have lower long-term returns than short-term fixed income. They have higher volatility than the stock market. And they don’t help us hedge against inflation.

Unless we are able to predict what they are going to do going forward (and we certainly can’t), there is no reason to want them in your portfolio. In nearly all cases over the long term, commodities will lower your portfolio’s return and increase your portfolio’s volatility.

It may be boring, but the standard, broadly diversified stock and bond portfolio built around taking an appropriate amount of risk for you is still the best solution for helping you meeting your goals. And that’s what investing is all about—meeting your goals, not shooting for a high score.

 

Footnotes:

[1] Data computed with a monthly returns series from the daily price series of Gold Fixing Price 10:30 A.M. (London time) in London Bullion Market, based in U.S. Dollars. The starting point of 1980 was chosen to avoid any issues caused by the use of a gold standard for currency, especially in the United States. ICE Benchmark Administration Limited (IBA) and London Bullion Market Association, Gold Fixing Price 10:30 A.M. (London time) in London Bullion Market, based in U.S. Dollars [GOLDAMGBD228NLBM], retrieved from FRED, Federal Reserve Bank of St. Louis; https://fred.stlouisfed.org/series/GOLDAMGBD228NLBM, June 21, 2016.

[2] This is why you don’t want to hedge something with low volatility (inflation) with something with a high volatility (gold).

[3] For this analysis, we will be using West Texas Intermediate Crude Oil as a proxy for oil in general. Oil is traded in specific, predefined grades since the exact composition of the oil is different depending on where the oil is from. The returns of the different grades of oil are highly correlated. I ran the analysis with multiple grades, and the differences are insignificant.

[4] Returns computed from the monthly Global Price of WTI Crude. International Monetary Fund, Global price of WTI Crude© [POILWTIUSDM], retrieved from FRED, Federal Reserve Bank of St. Louis; https://fred.stlouisfed.org/series/POILWTIUSDM, June 20, 2016.

[5] Data provided by Dimensional Fund Advisors. GIC Energy and Materials sectors.

 

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