Many investors and professional money managers over the past ten to fifteen years have allocated a significant amount of funds into the ‘commodity' asset class.
The reasons given for this allocation included equity-like long term returns, a guard against inflation and the printing of ‘fiat money' by world governments, and the promise of low correlations to other investments.
If these claims were accurate, most portfolios would benefit from adding the allocation in any manner, as overall long term returns would not be affected (or possibly even increase), risk would be decreased, and the investor would gain a valuable defense against future inflation pressures.
Since 2007 all these reasons to own commodities have been challenged. The correlation to equities went to near one in 2008/2009, returns from 2007 through 2014 have been much lower than other asset classes, and inflation has not been on the radar. Despite these concerns, most investors should consider some exposure to ‘commodities', but generally only in certain ways.
Understanding The Challenges
First to address the recent lackluster behavior of the asset class:
- High correlation to equities in 2008/2009: The most effective ways to invest in commodities will always have a high correlation to equities in the worst of times (but so will almost all other asset classes). This is not a reason to keep out, as for the vast majority of time there will be a correlation benefit and in a crisis such as 2008/2009 all asset classes except for some high quality bonds tend to be highly correlated.
- Lower recent returns vs. most other asset classes: Although most commodities have lagged real estate and traditional equities over recent years (with one major exception), all asset classes will have periods of relative underperformance. It makes sense that commodities lagged since the 2008 crash, as going into that period they looked overvalued and inflation has been very low. As certain factors change commodities once again can shine.
- Low/No Inflation: Inflation has been very low since 2008/2009, with yearly inflation rates running between one and two percent for the majority of the time. As long as an investor gains access to commodities the right way, good long term average returns can come with high inflation or not. If higher inflation does come there should be some added benefit.
The Best Ways To Invest In Commodities
- Commodity Producing Equities: Although this approach sacrifices the lower correlation advantage to domestic and emerging equities, the efficiency and long term returns of this method are very positive. In addition, investors who choose an active manager who can isolate ‘lowest cost' producers can take advantage of one of the most durable ‘wide moat' assets around.
The ‘wide moat' in this case is the competitive advantage of producers created by their unique access to the companies' commodity reserve. RS Natural Global Natural Resources Fund (RSNRX), Global Commodity Equity ETF (NYSE: CRBQ), and Ivy Global Natural Resources A (NASDAQ: IGNAX) are all solid options in this space. Note: RSNRX has now been soft closed, and can only be purchased by investment managers/investors who already have positions.
- Master Limited Partnerships: This area of the commodity market has had an incredible run over the past five years with the Alerian MLP Index returning almost 150 percent and beating the S&P 500 over that same period by 45 percent!
The MLP sector of the commodity asset class offers very attractive tax benefits, access to the growing domestic natural gas/shale energy plays, and high cash yields around five percent. Good investment ideas in this area include UBS Etracs Alerian MLP ETN (NYSE: AMU) and UBS Etracs Alerian Natural Gas MLP ETN (NYSE: MLPG). Note: Both of these funds entail the credit risk of UBS and do not actually hold any MLP equities.
Questionable Ways to Invest in Commodities
- Managed Futures: This is truly an alternative area of the commodity area, with limited correlation to equities or much else. Managed futures performed well in 2008, with many funds producing positive returns while stocks were down by almost 40 percent! Since 2009, however, the vast majority of managed future strategies and funds have performed poorly.
While commodities and stocks have surged since the 2009 bottom, most managed futures funds are up marginally or little changed over the past few years. Management fees and fund construction costs run very high (two to three percent or more) adding to the total return problem.
- Commodity Index Price Return: Several funds and ETFs attempt to mimic the price return of a single commodity or a basket of commodities. This is almost impossible to do efficiently over the longer term. The only way to obtain true access to the price returns of commodities is to buy a series of long future options and keep rolling them as the older ones expire.
This approach is costly, fees are high, and over long periods of time the price return of commodities has not been historically much above inflation. For shorter term inflation spikes however, this strategy might make sense.
- Commodity Future Curve Maximization Strategies: These strategies attempt to take advantage of the shape of commodity curves. Some try to go both long and short different commodities (depending on curve shape) to take advantage of ‘roll' yield and demand/supply imbalances. Again, fees tend to be high here and returns have to this point been disappointing with most strategies and funds.
Eric Mancini is the Director of Investment Research at Traphagen Financial Group (www.tfgllc.com), which is located in northern New Jersey.
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