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Why commodities belong in your portfolio

The recent commodities bear market – 2008 to 2020 – was like watching a faraway, failed state descend into chaos. Hard to understand, it went on for years, and all you really knew was that you didn’t want to go there. Hence I’d guess that many Monevator readers instinctively recoil from the very idea of commodities investing.  

But ongoing research and long-term data pieced together by multiple teams of investing academics suggests that commodities have been unfairly tarnished.

What happened to the asset class in that slump is most likely explained by a terrible sequence of returns. Bad luck for commodity investors, but a perfectly standard manifestation of investing risk. 

If that thesis is correct, then by ruling out commodities we make the same mistake as a risk-shy investor who has a lifelong aversion to equities because they came of age during the Great Depression. 

The bigger picture – filled in by 150 years worth of investment returns – is that broad commodities deliver excellent results over time, can diversify equity / bond portfolios, and boast some inflation-hedging capability, too. 

  • Please read our commodities investing explainer for our intro to the asset class, how it works, and the drivers of return that make it profitable. 

The ghost of futures past

The following long-run UK returns chart shows why commodities futures are worth a second look:

A commodity returns chart from 1870 to 2022

Data from AQR1, Summerhaven2, JST Macrohistory3, and FTSE Russell. May 2023.

Since 1870, equal-weighted commodities have delivered a surprisingly good annualised real return of 4.3%. 

Meanwhile, UK equities paced ahead with a 5.3% return, while government bonds brought up the rear on 1.4%. 

Investing returns sidebar – All returns quoted in this piece are real annualised total returns. That is, they’re the average annual return (accounting for gains and losses) realised in a given time period. These returns include the impact of reinvested dividends and interest, but strip out the vanity growth delivered by inflation that does nothing to boost your spending power. Commodities dollar returns have been converted to GBP4.

Equities’ stronger returns mean we could forget about commodities if all that was happening was that shares and commodities rose and fell in synchronicity.

But the chart above also shows that commodities wax and wane to a different beat.

They’re highly volatile, but the fact that they often perform when equities (and bonds) falter is central to the pro-commodities case

They’re also a potent diversifier because the record shows that they’ve delivered superior long-term returns compared to gold, cash, or bonds.

Reality check 

Before we go any further, I have to deliver a reality check that takes the gloss off these results. (Although with that said it doesn’t undermine the nub of the issue: that commodities generate good returns – and otherwise unattainable diversification benefits – for a passive investor.)

The 150-year index shown above enables us to see the long-term pattern of commodity returns. But that index is very difficult to actually invest in. 

That’s because the Summerhaven and AQR research teams behind the historical data reconstituted it as an equal-weighted commodities futures index. 

This is a standard academic practice. It apportions the same weighting to every commodity futures contract included in the index. 

However there’s currently only one broad commodities ETF that tracks an equal-weighted index – and it excludes agricultural products. 

The majority of commodity indices weight their constituents by world production quantities and / or trading volume. 

This method is intended to represent the global economic significance of each commodity type. (Just as equity indices represent firms according to their market capitalisation.)

The issue is that production and liquidity-weighted indices typically underperform their historical equal-weighted counterparts. 

So to ensure we stay firmly grounded in the real world, I’ll only use data from historically investable commodities indices for the rest of these articles. 

Happily we have just such an index going back to 1933, thanks to the forensic efforts of Summerhaven’s research team. They published the data alongside their paper The First Commodity Futures Index of 1933

Their reconstruction of the Dow Jones Commodity Index can be directly linked to the contemporary Bloomberg Commodity Index, which is tracked by some of the largest ETFs in the space today. 

Do long-term investable commodity returns stack up? 

Thankfully, still yes. Here’s the chart:

Commodities versus UK equities returns chart from 1934-2022

Data from Summerhaven5, S&P GSCI TR, BCOM TR, A Century of UK Economic Trends, and FTSE Russell. May 2023.

The annualised return of commodities is 4.5% versus 5.5% for UK equities over this 89-year timeframe. Bonds dawdled along at a paltry 0.85%. 

Happily, aside from confirming that investable commodities deliver very handy returns, the chart also demonstrates that commodities often soared when equities stumbled. 

You can see commodities spike as equities sold off during World War Two, again in the early 1950s, and incredibly so in the stagflationary ’70s.

The same happens in reverse, too. Equities did the heavy lifting when commodities crashed in the aftermath of the Credit Crunch. 

How do commodities help as a portfolio diversifier?

The next chart shows how the main diversifying asset classes performed in years when equities were down, from 1934 to 2022.

A chart showing how commodities help diversify investor returns when equities fall

Even at a glance, the cyan bars tell us that commodities sometimes spectacularly outperform everything else. 

That’s true in 1939 and in the post-war years of 1947 and 1949. It happens again in 1973, during the first leg of the UK’s worst-ever stock market crash, the opening innings of the dotcom crash in 2000, and most recently in 2022. 

There are also times when commodities are the only asset class that registers a positive return, while the others burrow into the ground. 

Indeed, commodities are the best asset in the portfolio 32% of the time. That’s a record only bested by cash’s 34% score. And cash earns pitiful long-term returns by comparison. 

Yet the fact remains that commodities can be a difficult bedfellow. They made portfolio returns worse in 42% of the years examined in our chart above. (Of course this also means they improved portfolio returns 58% of the time…)

Commodities won’t always bail you out. Sometimes they’ll make you rue the day. But there have been crises when they were the only thing that worked. 

We’ll examine how much commodities improve overall portfolio performance across the entire 89-year timeframe in a future post in this series.

Commodity correlations 

A correlations asset class matrix can help us assess the diversification benefit of commodities over different periods. An effective diversifier registers low positive or negative numbers against the other main asset classes.

Asset class returns correlations: annual returns 1934-2022 (inflation- adjusted)

Commodities UK equities Gilts Cash Gold
Commodities 1 -0.11 -0.16 0.05 0.37
UK equities -0.11 1 0.39 0.08 -0.21
Gilts -0.16 0.39 1 0.29 -0.05
Cash 0.05 0.08 0.29 1 0.04
Gold 0.37 -0.21 -0.05 0.04 1

Gold data from The London Bullion Market Association and Measuring Worth. Cash is UK Treasury Bills data from JST Macrohistory and JP Morgan Asset Management. Other assets as per previous charts. May 2023.

Quick correlation recap:

  • 1 = Perfect positive correlation: when one asset goes up so does the other
  • 0 = Zero correlation: the two assets being measured have no influence upon each other 
  • -1 = Perfect negative correlation: when one asset goes up, the other goes down

On this measure, commodities look like an excellent diversifier. The asset’s slightly negative correlation with equities and gilts means that it will sometimes spike when they stall or fall. 

Of course this also means that commodities can hold a portfolio back when shares and bonds are steaming ahead. But on balance, the historical record shows the asset class is a net positive. 

One of the exciting things about these correlation numbers is you rarely see other assets produce a combination of numbers that gel so well with equities and bonds and deliver strong long-run returns. 

By way of contrast, gold’s weak results over extended time periods (and the lack of a strong economic rationale for decent expected returns in the future) make me nervous about owning significant quantities of the yellow metal. 

Most of us buy into the idea of equity and bond diversification – even though they’re relatively highly correlated, and thus likely to be less effective diversifiers at times. 

Once again, it’s the combination of strong positive returns and low correlations with equities and bonds that make commodities worthy of serious consideration.

2008-2020 be damned!

Well, maybe…

Commodity drawdowns and crashes

I still can’t help being scared by that horrendous -66% commodities drawdown lasting from June 2008 to April 2020. 

Other lowlights include a 20-year bear market that dragged on from 1951 to 1971. And another -62% beasting that ravaged commodities from the end of 1974 to the beginning of 1982.

Overall there are several lost decades to wince at. Especially if we go back to the 1870s via the equal-weighted index.

By the way, don’t forget that these figures are real returns. Most commentators will talk about crashes and bear market recoveries in nominal terms – a much gentler standard. 

However it’s my duty to tell you that commodities investing is no easy ride. Although historically they’ve been a touch less volatile than equities.

On that note, it’s important to remember that all this and worse has also happened to the other asset classes we stake our future wealth on. 

UK equities caved -79% from 1972 to 1974, for instance. The UK’s worst bond market crash also plunged to -79% depths, from 1935 to 1974. Gold suffered a near 20-year bear market between 1980 and 1999.

Nothing is ‘safe’. 

If commodities still give you the willies, I can only say I’m right there with you.

They’re an unfamiliar asset class that works in an arcane way. And we’ve just lived through one of the worst commodities drawdowns on record. 

None of that helps my rational self override my emotional self. 

Which begs a serious question…

Are commodities a broken asset class?

Was the 2008 to 2020 losing streak just a bad bear market, or did something fundamentally change to impair the future fortunes of commodities? 

To answer this question, let’s bring in the big guns. Namely the venerable financial academics Dimson, Marsh and Staunton (hereafter DMS). 

DMS looked at precisely this question as part of their commodities investing chapter in the Credit Suisse Global Investment Returns Yearbook 2023

A particular concern is that the launch of commodity index trackers shortly before the Global Financial Crisis – and the concomitant flood of institutional investment capital – might have led to a permanent reduction in the historical advantages of the asset class.

DMS highlighted three possible dangers associated with the ‘financialization’ of the relatively small commodities market: 

First, inflows could have lowered the risk premium through the increased competition in the provision of insurance to hedgers. Second, because institutional investors hold portfolios of commodities and their allocation to commodities competes to some extent with that to other assets, their activities might increase the correlation between individual futures, and between futures and other asset classes. Finally, passive index investments might weaken the link between futures prices and fundamentals. 

However, DMS then go on to survey the work of other researchers who’ve examined this question and say:

The authors conclude that, despite the high growth in commodity markets during this decade, the proportion of hedgers and speculators was broadly constant. Nor, in terms of risk and return, was this decade significantly different from the longer historical experience. Correlations between commodities rose, then fell again. The authors attribute this to the Global Financial Crisis, not financialization. 

Citing additional evidence, DMS judge that:

It would seem quite wrong, therefore, to conclude that the risk premium from futures had disappeared simply because of the Global Financial Crisis drawdown in commodity futures that followed the publication of GR’s [Gorton and Rouwenhorst] research. This was a disinflationary and low inflation period, and, as we will see below, these are challenging conditions for commodity futures. 

DMS go on to show that commodities tend to perform poorly during recessions and disinflationary periods, concluding: 

The disinflationary decade following the crisis was a very difficult time for commodities. Many institutions capitulated, reducing or removing their commodity positions – before they turned useful again in 2021/22. It is harder for investors to stay the course in commodities than equities amid a comparable drawdown, given that commodities are less ‘conventional’. This can be a typical fate for a good diversifying asset. 

Indeed, the academic trio believe that the commodities risk premium remains alive and well: 

What risk premium should we expect from a long-run investment in a portfolio of collateralized futures? Ilmanen (2022) concludes that the best long-term, forward-looking estimate is the historical premium. He suggests that “a constant premium of some 3% over cash seems appropriate for a diversified commodity portfolio – though not for single commodities!” 

Other researchers float that 3% excess return figure too as the average long-term return you would hope to gain over and above the interest rate earned on cash in the bank. 

Vanguard’s 2023 commodities paper for instance employs an expected returns model to draw in data beyond the historical record. It proposes a highly finessed base-case estimate of a 2.85% future expected excess return.

Though it then hedges its bets by citing a range anywhere between 0.5% to 3%.

Where does this leave us?

It’s because I think we should all hedge our bets that I’m writing this commodities series in the first place. 

I want to evaluate the evidence for and against as well as I can, especially as it’s an asset class with enough ifs, buts, and maybes to fill a comedy of manners. 

Perhaps we need to move on from considering the strengths and weaknesses of commodities in isolation? After all, what really matters is their potential contribution as part of our properly diversified portfolios.

Let’s get to that in part three. 

Take it steady,

The Accumulator

  1. Levine, Ooi, Richardson, and Sasseville. “Commodities for the Long Run.” FAJ, 2018. []
  2. Bhardwaj, Geetesh and Janardanan, Rajkumar and Rouwenhorst, K. Geert. 2019. “The Commodity Futures Risk Premium: 1871–2018.” []
  3. Òscar Jordà, Katharina Knoll, Dmitry Kuvshinov, Moritz Schularick, and Alan M. Taylor. 2019. “The Rate of Return on Everything, 1870–2015.” Quarterly Journal of Economics, 134(3), 1225-1298. []
  4. British Pound Sterling []
  5. Bhardwaj, Geetesh and Janardanan, Rajkumar and Rouwenhorst, K. Geert, “The First Commodity Futures Index of 1933,” Journal of Commodity Markets, 2020. []
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Weekend reading: dead serious on inheritance tax

Weekend reading: dead serious on inheritance tax post image

What caught my eye this week.

Last month we discussed how many more people are being taxed at the highest rates of income tax than ever before.

And despite a spirited rearguard action from a few old-timers who say you wouldn’t believe the tax they paid back in their day (days when you could still buy the average home for four times even a slightly higher-taxed salary, incidentally…) the consensus was that enough will soon be enough, if it’s not already.

Unsurprising perhaps, given we also learned last week that a majority of Monevator readers are higher or additional-rate taxpayers.

Turkeys are not renowned for their love of the roasting tray.

Same old question

So here’s a more contentious challenge – especially for the higher-earners among you who feel overtaxed right now.

The Telegraph recently launched a tub-thumping campaign to abolish inheritance tax (IHT). Veteran Monevator readers know IHT is my favourite tax. But the UK population hates it.

For whatever reason, the typical person would rather we tax hard work over a lifetime than someone who just happens to pop out of a particularly auspicious uterus through no effort of their own – a scenario where if anyone deserves a big wealth windfall it is surely the gasping and pained owner of said uterus, not the newcomer riding the slip-and-slide into human civilization.

I would continue, but happily ex-Telegraph leader writer James Kirkup has done so less sloppily in The Spectator this morning.

He writes:

I like IHT and so do a lot of people like me: professional policy wonks and economists, who proliferate at Westminster and often get a lot of prominence in political debate – especially on Twitter

My technocratic tribe largely regards inherited wealth as harmful to social mobility and economic efficiency. We’d rather see large accumulations of wealth redistributed by the state than cascade down to children who may already have enjoyed significant economic and social advantages […]

We get particularly enraged by arguments like ‘it’s double taxation’, since ‘double taxation’ is commonplace and unremarked on elsewhere.

Every pound of taxed income that you spend on VAT-rated items, for example, is being taxed twice.

Hear hear. Alas, Kirkup continues:

We’re all scared of dying and one of the few sources of comfort is the idea that when we do, we can leave something behind for the people we love; the power of that feeling is so strong that it doesn’t matter if your estate isn’t in any danger of incurring IHT. You’re still very likely to hate the idea of that tax and support its reduction.

Kirkup’s whole article is worth a read. He makes further pertinent points about the state of British politics and especially the still-benighted Tory party. More than 50 Conservative MPs apparently support the idea of this unfunded £7bn tax cut that benefits a mere 4% of the population.

Political titan Liz Truss is one of them, which would be enough to get the policy squirreled away into an old biscuit tin in the attic in a saner reality.

But what about you guys?

Heir-raising taxation

We mostly agree income taxes are too high.

But do you also call for the equivalent of a 1p hike in the basic rate so that already-advantaged kids can get everything they’re due but nothing they’ve earned for themselves?

Or do you accept that – unpleasant as it is – somebody has to pay the state’s way? And that it’s better to incentivise hard work and, dare I say it, entrepreneurship, than the feudal notion that every old Telegraph reader’s three-bed in the South of England should be their castle to be passed on unmolested to their by-then already mostly-well-to-do 40-to-50 something year-old offspring?

I’ll don my flame suit (I’m off to a BBQ next, it’ll do double-duty) though I’m not looking for a fight. Rather one of our considered discussion about the facts.

Which are: we’re poorer as a nation than we were, not least due to a previous populist decision we made a few year ago. That economically self-destructive move is already costing us at least £40bn in lost tax receipts. Yet someone has to pay to keep the show on the road – and it can’t all be done by the GDP-boost from record immigration.

So it’s a serious question. If you won’t tax the dead than who?

Have a great weekend.

From Monevator

Commodities investing: why we’re missing a trick – Monevator

Ego as a catalyst: why I see value being outed at this investment company [Mogul members]Monevator

From the archive-ator: How to estimate care home costs – Monevator

News

Note: Some links are Google search results – in PC/desktop view click through to read the article. Try privacy/incognito mode to avoid cookies. Consider subscribing to sites you visit a lot.

UK mortgage lending hits record low in sign of market stress – Guardian

Larry Summers blasts Brexit, calls it a historic economic error… – Proactive Investors

…meanwhile Eurozone inflation falls more than expected to 6.1% – CNBC

The S&P 500’s gains this year are almost entirely from five companies – Axios

Is your Barclays or Lloyds Group branch among hundreds closing in 2023? – Which

ESG-hostile activists in the US could break how Vanguard runs index funds – RIABiz

They came. They saw. They incinerated half their funds’ potential returns – Morningstar

Products and services

Building societies offering members regular saver rates up to 9% – Guardian

Annuity sales soar by 22% on much more attractive deals – This Is Money

Can you save money with a ‘green’ mortgage? – Which

Open a SIPP with Interactive Investor and pay no SIPP fee for six months. Terms apply – Interactive Investor

The tiny odds of winning nothing in a year with £25,000 in Premium Bonds – This Is Money

The best savings accounts in June – Be Clever With Your Cash

Open an account with low-cost platform InvestEngine via our link and get £25 when you invest at least £100 (T&Cs apply. Capital at risk) – InvestEngine

Return train tickets to be scrapped on LNER routes. A money-saver? – Which

Pastel-coloured homes for sale, in pictures – Guardian

Comment and opinion

Against index funds, part II – Fortunes & Frictions

Have index funds become growth funds? – Morningstar

Don’t bet on market timing – Humble Dollar

Inflation is widening the gap between private and public sector pensions – This Is Money

Other people’s money – Humble Dollar

A discretionary withdrawal strategy for early retirement – Mad Fientist

Introducing the weird portfolio [Few weeks old]Portfolio Charts

Do you need a ‘Mary Jean’ list to help your other half or kids? – Humble Dollar

Regret-optimised portfolios and optimal retirement income [Podcast]Rational Reminder

Naughty corner: Active antics

Weddings and divorce: the scourge of investment returns [Search result]FT

Working hours in hedge funds vs. private equity – eFinancial Careers

How to build defensive equity portfolios – Advisor Perspectives

Why people continue to invest in active funds – Financial Samurai

How to avoid dividend stocks with excessive debts – UK Dividend Stocks

Why down-and-sideways markets are bullish – Of Dollars and Data

Sector expertise doesn’t typically generate alpha for fund managers – Finominal

Kindle book bargains

A Man for All Markets by Edward O. Thorp – £0.99 on Kindle

Liar’s Poker by Michael Lewis – £0.99 on Kindle

Love, Pain, and Money: The Making of a Billionaire by John Caudwell – £0.99 on Kindle

Crickonomics: The Anatomy of Modern Cricket by Stefan Szymanski and Tim Wigmore – £3.79 on Kindle

Environmental factors

What ‘rewiring’ an economy means for investors – Schroders

Why cultivated meat is still so hard to find in restaurants – BBC

Black sea urchins have disappeared, threatening a coral reef – CNN

Huh, our fake beach is good for baby sharks – Hakai

Pesticide firms withheld brain toxicity studies from EU regulators – Guardian

In defense of flies – Vox

Robot overlord roundup

AI ‘godfather’ Yoshua Bengio feels ‘lost’ over life’s work – BBC

Is an AI stock market bubble inevitable? – A Wealth of Common Sense

AI-controlled military drone ‘kills’ its operator in simulated test – Guardian

Tech giants have been investing in AI for years – Crunchbase

Off our beat

Tarzan FIRE [Sort of on our beat!] New York Post [h/t Abnormal Returns]

Can humans ever understand how animals think? – Guardian

Paying attention – Morgan Housel

Multi-cancer blood test shows real promise in NHS study – BBC

One of the world’s most controversial philosophers explains himself – Vox

The power of staying put [Podcast] – Morgan Housel, again, via Spotify

It’s good that we now do vital government business on burner phones, like drug dealers – Marina Hyde

Is Apple’s weird headset the future? – Vox and FT [Search result]

Why our allergies are getting worse – NPR

And finally…

“The cowards never started and the weak died along the way. That leaves us, ladies and gentlemen. Us.”
– Phil Knight, Shoe Dog

Like these links? Subscribe to get them every Friday. Note this article includes affiliate links, such as from Amazon and Interactive Investor.

{ 95 comments }

Commodities investing: why we’re missing a trick

The time has come to talk about commodities. Chances are you don’t hold a position in this asset class, despite its low correlation with equities and bonds. And despite the fact that it’s often lauded as an inflation hedge

If you’ve looked into commodities at all – beyond flirting with gold – then you probably walked hurriedly away murmuring, “nothing to see here” at the sight of the -60% car crash that totalled the market from 2008 to 2020. 

But then came inflation – and over the next two years commodities smashed it. Gains north of 30% in 2021 and 2022 even while other assets bombed. 

Are we all missing an important diversifying asset that actually does defend against inflation? 

Keeping the faith

Even while investors were throwing their unwanted commodities overboard, investment academics kept at work, cracking the code of this most misunderstood of asset classes.

Were commodities really broken? Or was the recent twelve-year bear market just a completely normal case of investment risk incarnate?

As it turns out, the academic research suggests the stench of complexity and negativity hanging around commodities masks a valuable portfolio diversifier that can deliver strong long-term returns. 

Which brings us to this article – the first in a Monevator mini-series to explain, demystify, and marshall the data on commodities.

Because – whisper it – this may well be the ‘alternative’ asset class many of us are searching for. 

Here’s how the series will pan out:

  • Part one (this piece) is a commodities explainer. Let’s see how the asset class works. 
  • Part two digs into the research showing the role commodities can play as a strategic diversifier. 
  • Part three is on the difference commodities can make to the portfolio returns of UK investors. 
  • Part four concentrates on commodities’ record versus UK inflation. 
  • Part five will scrutinise what investable commodities products are available. 

Right then. On with the explainer!

What commodities investing actually means

Investing in commodities as an asset class means buying funds with exposure to raw materials such as:

  • Energy products – for example oil and gas
  • Staple crops – soybeans, wheat, cotton, sugar, and more
  • Livestock – things that walk, like cattle and hogs
  • Industrial metals – aluminium and copper and the rest
  • Precious metals – gold, platinum, and other shiny stuff

An investment vehicle that holds a mix of these categories is known as a broad commodities fund. Passive investing versions exist as commodities ETFs. 

Single commodity ETCs1 exist too. But they don’t offer the same diversification benefits as a broad commodities product. 

So far so good. But from here, commodities funds begin to sound like the type of financial engineering that ends with the investing equivalent of the Titanic sliding to the icy depths. 

Bear with me though. There’s a strong economic rationale for commodities investing, plus a recently unearthed and impressive historical track record to support it. 

Commodity futures trading

The first weirdness to dissect is that commodity funds and ETFs don’t literally own herds of cows or fleets of oil tankers. Agribusiness and oil refining is not their bag. 

To avoid getting their hands dirty, they invest in commodity futures contracts. 

Commodity futures are derivatives that commit a fund to buying a quantity of a particular commodity at a specific price on a specific date. Say, two months from now. 

However the fund has no notion of ever taking delivery of said commodities.

To avoid their offices being overrun by cows, the canny fund manager sells their futures contract before the due date. But they’ll maintain their exposure to steers or longhorns or whatever by buying into a new, longer-dated futures contract. This, too, will be sold, further down the line, as the thunder of hooves draws near.

This manoeuvre is called rolling. It means the fund continually tracks each commodity – via a chain of ever-expiring future contracts – without ever being saddled with the costs or the raw reality of buying in bulk. 

Back to the futures

You might wonder why do futures even exist?

Well, commodity producers want to hedge against the possibility of adverse price movements before they’re ready to sell.

Meanwhile, buyers who actually need commodities to run their business must ensure continuity of supply. 

Investors get involved in the middle because there’s money to be made in supplying liquidity to the commodity futures market. 

Why commodities investing is profitable

The most counterintuitive thing you’ll discover today is that the return of a commodities futures fund or ETF has very little to do with the spot price of the underlying raw materials.

Spot price moves make up only a small component of a total return that is highly volatile but – over the long-term – only marginally less profitable than equities. And far superior to bonds. 

The total returns of a broad commodities futures fund derives from three sources:

  • Spot price changes
  • Interest on collateral 
  • The roll return (related to the rolling manoeuvre mentioned above)

The spot price is simply today’s price for a barrel of oil, or a bushel of wheat, or a ton of coffee. 

Interest is earned because a commodities fund diverts some of its capital into purchasing collateral that underwrites the risk taken on its futures contracts. 

But the roll return is the main source of long-term excess profits for investors. 

The roll return is the profit (or loss) the fund makes on trading futures contracts. 

Remember it’s a perpetual motion machine that constantly buys contracts with delivery dates some way off in the distance. Those self-same contracts are then sold off as D-Day looms, and are replaced by longer-dated versions. 

You’ve got to roll with it

Roll return is the difference between the price earned on the sold contract and the price paid for its replacement. 

If the short-dated contract is sold for a higher price than its long-dated replacement then the market for that commodity’s futures is described as being in backwardation

If the short-dated contract is sold for a lower price than its replacement, then the market for that commodity’s futures is described as being in contango

Backwardation good, contango bad.

Backwardation boosts commodities investing returns

A state of backwardation indicates the market expects the spot price to fall. Hence more distant contracts are cheaper than short-dated ones, and the fund should make a positive roll return when it sells and replaces the maturing contract. 

Contango lowers the returns of commodities investing

A state of contango indicates the market expects the spot price to rise. Now we’re in the reverse situation and facing a negative roll return when the short-dated contract is replaced with a more expensive one. 

Individual commodity futures markets flip between the two conditions depending on supply and demand.2

From our perspective, the important point is that commodity investment returns benefit from backwardation and are dragged down by contango. 

These states can last for long periods. The atrocious returns of commodity funds post-2007 was often linked to contango in the oil market for years after the Global Financial Crisis.  

However while individual commodity futures markets are highly volatile, they also enjoy low correlations with each other. 

This enables diversified commodity funds to descend into the broad commodities market like claw-craned arcade grabbers. 

The claw retracts clutching handfuls of winners and losers but, over time, the gains provide ample compensation for investors. 

Commodities investing: the underlying rationale 

There are two competing theories that seek to explain why commodities investing is profitable. 

The first is the theory of normal backwardation, attributed to John Maynard Keynes. 

Commodity producers want to lock in a minimum price to insure themselves against a dramatic drop in the value of their output, say at harvest time. 

Thus producers hedge against the possibility of loss by selling futures contracts to investors. They pledge their product for a price that could be lower than the one they’d receive if they waited until delivery day. 

Investors expect to be rewarded for offering this insurance and for taking on the risk that they may be overpaying for the commodities. Thus they set the futures price below the spot price they expect to prevail when the contract matures. 

If the investor has made a shrewd guess then they can theoretically sell the commodities for a profit. 

Although in reality, as discussed, they’ll punt the contract to a buyer who genuinely wants the goods. All being well, the investor still pockets a tidy profit as the value of the maturing futures contract converges upon the spot price.

The second rationale for commodities investing is known as the theory of storage

In this conception, the value of short-dated futures is bid up by commodity buyers who cannot risk their production line slowing down for want of raw materials. 

Once again, investors benefit if they’re able to purchase long-dated contracts for a relatively low cost, and then later cash in, when buyers flood into the market like forgetful husbands who’ll pay stupid prices for flowers come Valentine’s Day. 

Wake up and smell the coffee, the crude oil, and the hogs

These theories help explain why a long-term risk premium should exist for commodities futures – making them more profitable than sitting in cash. 

Without the promise of that premium return, there’d be no reason for investors to create the market. Eventually it would dry up. 

But theory is not enough. We rational investors want to see it backed up by a historical track record of positive results.

It turns out there is one. That will be the topic of my next commodities post

Take it steady,

The Accumulator

  1. Exchange Traded Commodities []
  2. The grubby realities of handling real-world commodities are also a factor. For instance, it costs money to store oil. And wheat rots. []
{ 31 comments }

Weekend reading: earning learning

Weekend reading: earning learning post image

What caught my eye this week.

The results are in from last week’s poll (now closed) and in news that will shock no one, it turns out that the readers of a personal and investing website are in general earning much more than the average UK citizen.

Over 2,000 of you voted – thanks! Your votes confirmed that a majority of Monevator readers pay higher-rate taxes:

Indeed going by the poll results, more than a fifth of you pay additional-rate taxes.

That high score does slightly surprise me. The figure nationally is around 1% of the adult population.

Perhaps higher-earners are more likely to want to tell us about it in polls?

And maybe I should cajole Finumus into writing more mundane stuff about household accounts for the very wealthy among you?

Or maybe not: he’d have you putting the family home into an offshore vehicle that you securitise on the Moldavian Stock Exchange by teatime…

How much?

I’m often surprised by how much some people earn. Blame my long years of Bohemian living like a graduate student – plus my multi-decade avoidance of the office.

In a standout example, I learned this week that an old friend took home £600,000 last year.

I knew he was world-class at his job, and that his employer is the best in the field. But that field is not financial services – nor money-laundering, racketeering, or producing hip-hop records.

And my friend is a wage slave (still 15-hour days in his late 40s, he claims, at times) not an entrepreneur.

A bit more interrogation revealed 2022 was an outlier thanks to some massive bonuses, but still.

We were talking about general investing, and as my friends tend to he’d asked for some thoughts about something. In the subsequent conversation I’d guessed his salary – I thought generously – at about £150,000.

He looked at me without saying anything for a moment. Not unkindly.

Everyday high earners

Are you feeling hard done by? Remember my friend is an extreme outlier. Nearly everyone earns a lot less.

An annual salary of just over £60,000 a year puts you in the top 10% of wage earners:

Source: Statista

At least I think it does. Unfortunately Statista restricts access to the source for this data to subscribers; I presume it’s from the ONS.

Note that if you randomly Google around, most reports discuss ‘household income’. That includes all sorts of non-salary income – and in many cases the earnings of multiple people.

Cheap cuts

It was my friend’s turn to be shocked when I said I’d only paid higher-rate taxes in a handful of years. Even after I explained I’d used SIPP contributions to mitigate the impact.

My friend has been prudent with saving and investing, and is no spendy oligarch. Lots squirreled away, mostly lives in a two-bed flat – though there is a holiday home and buy-to-lets – and one where the kitchen has been unusable for a year (another story).

Nevertheless, we were speaking a totally different language on income. I was in mild shock for the rest of the evening; I think he was in turn unsettled by my earnings profile, too.

He’s now looking to downshift his family’s life or even to retire – our conversation was basically about ‘the number’ – and is mulling doing a couple of years in a less pressured and more enjoyable role as an off-ramp.

A big salary cut, obviously. He reckons to about £150,000 a year.

You can know the statistics but it’s always different with revelations from friends. Whatever you tell yourself in the cold light of day, or from a soap box in the comments on a blog. (Anticipating? Moi?)

I walked the long way home, wondering for a bit if I’d done something wrong with my life. I decided I hadn’t – I couldn’t hack his work-life for a week – but it did make me think.

No bad thing. Just not too often!

Have a great weekend.

p.s. A couple of readers who have signed-up for membership were confused when they couldn’t access yesterday’s article on the site. Remember we have two tiers – essentially passive and active, though it’ll be a bit cloudier in practice. If you’ve joined the lower-priced Mavens cohort (thank you!) then you can’t read the naughty Mogul stuff. High-rolling Moguls can read everything. I’ll look for a way to make the paywall clearer.

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