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Weekend reading: Commodities are risky and typically unrewarding

Weekend reading

Good reads from around the Web.

Until you pay attention – as more of us have with ongoing the oil price crash – it’s hard to fathom just how volatile commodities can be.

Even veteran investors who have a handle on the ups and downs of the stock market can turn seasick looking at a graph of the choppy pricing of copper, corn or gold.

The stock market can seem a millpond by comparison.

The following table from US Global Investors1 shows how a metal like nickel can soar 154% one year before slumping 24% and then a further 55% in the following two years, and then rally 59%!

Table of commodities returns

Click to increase the chaos.

The original graph is interactive. Hours minutes of fun!

Slippery slopes

Being aware of this volatility obviously matters a lot if you’re an active investor.

It’s easy to get sucked into buying, say, oil exploration companies because they’ve fallen 20% on a 10% dip in the oil price.

After the oil price has fallen 80% and your shares are down 90%, you can reflect on your haste at your leisure.

Personally, I think commodity prices in today’s globalised and ‘financial-ised’ world are probably unpredictable even by experts.

That doesn’t mean you can’t invest in companies that churn them out, but it does imply that as a stock picker I want to be buying firms I judge can do well over a wide range of prices.

Now, many amateur experts will (in the good times) say different.

Hoards of private investors became part-time experts on the oil and gas industry, for instance, over the past decade, and on small cap gold mining companies for much of it, too, and loaded up their portfolios to the seams with such shares when prices were high.

And many have lost at least half their shirts in the subsequent rout.

I’m not belittling their expertise or ambitions. (That would be pretty hypocritical of me, given I am equally barmy in engaging in active investing myself.)

But I would observe that correctly judging which is the superior small cap oil company can be a hollow victory if it means that when the whole sector falls by 90%, you only lose 80% of your investment.

In this case you’d clearly have been better off out altogether. But from observation it seemed that many experts were wildly over-exposed – and emotionally committed – to the sector, and they followed the market down.

I’m not saying there’s never a time to invest in such companies. (Disclosure: I hope now is such a time, as I’ve loaded up, on and off, over the past 3-6 months).

But in my opinion, the hugely volatile nature of commodities means an active investor in the sector needs to be a confident trader, too, who is prepared to chop and change based on (gasp!) price action.

Passively poorer

Passive investors should also be aware of commodity price volatility.

That’s because every so often – usually after a couple of good years for the asset class – some people will start advising you to add direct commodity exposure to your portfolio as a diversifier.

I don’t mean to buy the major oil companies or miners that you will have exposure too anyway via your index funds.

I mean specific commodity exposure, through Exchange Traded Products or some other sort of futures fund.

From his own research, my co-blogger The Accumulator has typically been wary of that advice, and the latest US data suggests he is right to be cautious.

The following table – tweeted out by Morningstar’s editor-in-chief Jerry Kerns – shows how commodities have generally done nothing good for portfolios over the past 15 years:

A table of portfolio returns including commodities.

Commodities: Don’t bother.

Buy the dip?

Now you might be thinking this all sounds a bit defeatist. Don’t we normally suggest that slumps in a market can be a good time to buy in?

Well, I think that’s possibly true of companies that produce commodities, as I’ve alluded to above.

But being exposed directly to commodities themselves is a different matter.

Many financial assets – houses, equities, land – greatly appreciate in real terms over the long-term, despite the ups and downs on the way.

But there’s much less of that long-term appreciation in commodities in real terms, because we get better at extracting them and at exploiting them.

Perhaps someday that will change (that’s what the commodity super-cycle theory was all about) but it’s not done so yet.

And at the same time the prices are very volatile, so you’re basically adding risk without reward.

There are also extra costs and technical reasons why getting exposure to commodities via financial assets can be disappointing, too.

Let the smart money figure it out

As always, there will be exceptions – a few rare and successful market timers, whether by luck or skill, and some hedge funds and the like that have managed to get good returns over multiple cycles from the commodities markets.

But generally, I believe most people will be better off just owning whatever the global stock market owns when it comes to commodity-extracting companies.

And to leave directly buying the stuff for trips to the petrol station!

From the blogs

Making good use of the things that we find…

Passive investing

Active investing

Other articles

Product of the week: With the Bank of Japan imposing negative interest rates and the US economy slowing, global interest rates look stuck lower for longer. Peer-to-peer lending can boost returns on cash, but be very aware of the greater risk (your savings are not covered by the FCA compensation scheme, so there’s a low but real possibility that you could lose it all). I have been getting around 3% from RateSetter’s monthly market, but you can get near to 6% if you lock away your money for several years. You can also pick up a £100 new account bonus (and they’ll give me £50 as a finder’s fee if you follow the following link!) See RateSetter for more.

Mainstream media money

Some links are Google search results – in PC/desktop view these enable you to click through to read the piece without being a paid subscriber of that site.2

Passive investing

  • Video: Don’t cower in cash just because stock markets fall – Motley Fool

Active investing

  • Being wrong and still making money – A.A.I.I.
  • Seth Klarman lost money in 2015 – Business Insider
  • Saudis “will not destroy the US shale industry” – Telegraph
  • Strong case for value investing in Japan [Search result]FT
  • Lord Lee shares investment tips [Search result]FT
  • An interview with James Montier about Smart Beta and more – A.P.
  • Reasons for the fearful to be fearful of gold – Bloomberg

A word from a broker

Other stuff worth reading

  • London rents too high even for young bankers – Reuters
  • Morgan Housel: How to make the world richer – Motley Fool (US)
  • There are cons, too, to the oil price crash – Economist
  • How pension changes could hit you, by age [Infographic]Telegraph
  • Is it worth moving your BTL into a limited company? – ThisIsMoney
  • Free financial advice… at the food bank – The Guardian
  • What does money mean to you? Take the test! – The Guardian
  • Is American olive oil about to have its moment? – Bloomberg
  • Revolt against the posh boys – Bloomberg View

Book of the week: Anthony Bolton’s Investing Against the Tide came out a few years ago, but I’m just getting around to reading it. If you’re a novice stock picker (or a slow learner…) you might feel it’s a bit flimsy – there’s no equations or rules in bold text. But after more than a decade at the active investing coalface, I now believe any skill in investing in today’s overwhelmingly efficient markets is of the marginal gains variety, and more reflective of an art than a science. Bolton’s anecdotal advice speaks to that. Of course most people will always be better off investing passively, but if you’re going to go down the stock picking route then at least Bolton has the chops to back up his soft-sell wisdom. He achieved around 30% averaged over several decades whilst running big funds for Fidelity – one of the greatest track records of all time. Not that you would know it from his very modest prose.

Like these links? Subscribe to get them every week!

  1. Via Abnormal Returns. []
  2. Note some articles can only be accessed through the search results if you’re using PC/desktop view (from mobile/tablet view they bring up the firewall/subscription page). To circumvent, switch your mobile browser to use the desktop view. On Chrome for Android: press the menu button followed by “Request Desktop Site”. []

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{ 35 comments… add one }
  • 1 Neverland January 30, 2016, 12:52 pm

    Is there really a difference between investing in companies and investing in gold and other commodities?

    The reason for this column investing in house builders in 2012 (?) was mainly government action to stimulate house prices

    The reason for investment in commodities in the new century was the allegedly insatiable demand for raw materials from China and other Emerging Markets

    The argument that commodities are a losing game because supply rises to meet demand equally applies to most industries (with the exception of highly regulated ones perhaps)

    Let’s look at Facebook’s “economic moat”. It had to pay $1bn for Instagram a 2/3 year old company with 8 employees and then another few billion for WhatsApp

    I tend to find that most great returning investments in sectors start when everyone hates them

  • 2 Gregory January 30, 2016, 1:06 pm

    Emerging market indicies, Australia=commodity exposure.

  • 3 The Accumulator January 30, 2016, 1:42 pm

    I rejected commodities cos their long term record shows they don’t outperform inflation. Equities do.

    Moreover, the funds I could access generally didn’t access commodities directly but invested in commodity futures. Acres of research into those suggested that little of the return was directly due to the underlying commodities themselves and was oft hostage to various opaque processes that seemed best left alone.

    A shame, as I would have liked the diversification but the reality doesn’t match the promise of the theory.

  • 4 The Accumulator January 30, 2016, 1:42 pm

    The money test is fun. Here’s my scores:

    Money avoidance: 9 out of 24

    Your score on the money avoidance scale suggests that you are not vulnerable to money avoidance beliefs.

    Money worship: 9 out of 24

    Your money worship score suggests that you do not endorse significant levels of money worship beliefs.

    Money status: 4 out of 24

    Your score on the money status scale shows that you do not hold money status beliefs.

    Money vigilance: 13 out of 24

    Your money vigilance score indicates that you endorse money vigilance beliefs.

  • 5 Gregory January 30, 2016, 1:45 pm

    If You really want physical gold ask Your dentist:)

  • 6 Planting Acorns January 30, 2016, 1:49 pm

    Thanks TI another interesting piece. I wasn’t considering ‘diversifying’ into commodities in any case – as a private investor there seems no ‘good’ way to invest in them… I’d be wary of any product that was synthetic and involved counterparty risk – come another credit crisis I think the US / UK government will have to let a bank fail , public opinion will allow it regardless of the consequences.

    I had considered adding the BRCI fund, which looks amazing. But I wouldn’t know when to sell it so I’ve instead decided to follow TA’s capture whole market principles…

    I do wonder if ‘global property’ funds actually reduce risk for the same level of return over 15 years… Like most everyone else I ‘diversify’ into property fund but I hope Morningstar follow up one day with the equivalent research…

    As for the links… Seems the cost of passive investing will continue to fall, and it’ll be very interesting to see where we are cost wise in ten years time. I can’t wait to have enough invested to move to a fixed cost platform…as platform fees are currently higher than my averaged OCF’s ;0)

    @Neverland…
    I’ve just come back from a holiday in Cancun. Whilst there I kept in touch with my parents (late 60’s) in Spain and friends (mostly in 30’s) in UK. We also met people out there from Columbia and the US (20’s and 30’s)…all of whom I chatted to/ called via WhatsApp. I don’t know how you monetise it, but there can be no argument that if my parents are using it and 20 year old Columbians are using it…its taking over the world !

    http://fortune.com/2015/09/04/whatsapp-900-million-users/

  • 7 Rob January 30, 2016, 2:31 pm

    Commodities are not a viable asset class for investing for the simple reason that they do not generate any income. Any long-term investment study demonstrates that the bulk of the returns comes from reinvested dividends or interest. Commodities cannot provide that so will not generate the returns that bonds and equities do.

  • 8 The Investor January 30, 2016, 2:44 pm

    Is there really a difference between investing in companies and investing in gold and other commodities?

    @Neverland — Yes. You’ve totally missed the point in your usual haste to get a wayward opinion up pronto.

    Commodities the pseudo-asset-class are not the same as companies, and they are not the same as *commodity producing companies* as I have made clear in the article.

    For instance, in your example of housebuilders, the analogy with investing in commodities the asset class would be with buying houses (the good produced for sale) not with buying shares in housebuilding companies.

    (But houses would still be a poor analogy, because they have their own income producing capabilities etc, instead of just being a consumable good like a commodity.)

  • 9 StellaR January 30, 2016, 2:55 pm

    I avoid physical commodities, but have been buying Blackrock Gold & General which provides exposure to gold miners of various cap sizes. I think it is worth paying for an active fund or Trust when it comes to specialist sectors.

  • 10 Neverland January 30, 2016, 2:56 pm

    I think commodities could have a role

    The problem with commodities is their transaction and holding costs plus lack of a yield

    We now live in an age where bonds and cash also have negible yield (eg Japan and several European markets)

    Where bonds and cash have no yield and money creation is possibility are physical commodities a viable diversification?

  • 11 Planting Acorns January 30, 2016, 3:06 pm

    @Stella – I also believe this for emerging markets…because of the lack of transparency makes stock picking possible…do you agree?

  • 12 StellaR January 30, 2016, 3:16 pm

    Neverland, I think there is too high a risk for commodities to be regarded as suitable diversification for most investors at the moment – the Bloomberg article on gold provides some evidence of this. 3% interest in a bank account and good old premium bonds are my main diversifiers at the moment – and will provide funds for buying opportunities later, hopefully. And with premium bonds you get exposure to that rarest of commodities at the moment – hope for a big pay-out! 😉

  • 13 StellaR January 30, 2016, 3:23 pm

    Planting Acorns, on emerging markets: most of my EM holdings are in Investment Trusts. Over the longer term I believe an active approach is likely to prove more profitable – and many EM / Asia IT’s are on significant discounts at the moment. But I also have a small passive portfolio which I am drip-feeding into, so it will be interesting to see how the two compare in a few years’ time.

  • 14 Neverland January 30, 2016, 3:31 pm

    @stella

    We are going to have a Brexit referendum this year

    The bookies put a 30% chance on an exit vote

    If there was an exit vote there is a good chance of a sterling run

    How safe does that make your premium bonds?

  • 15 Justin January 30, 2016, 3:32 pm

    The commodity super cycle seems to be at the stage where the investing has been done and companies are reaping the benefits – lots of easier to access commodities to put to the market. We are also reaping the benefits of cheaper commodities, I put a lot more strength in this than I do lower demand causing falling prices.

    Because of this high output (supply) leading to low prices and demand staying relatively stable, I’m thinking commodity companies with a lot of debt are going to find it harder to cope, if interest rates rise. Could this lead to a wave of M&A? Could a large, profitable and debt-free company such as Aramco buy up lots of smaller US oilers for pennies on the dollar? Is Royal Dutch Shell PLC’s debt to equity of 0.34 high enough to cause it problems if/when rates rise? Compared to Exxon’s 0.19 its share price has performed much better in the face of falling oil prices.

  • 16 Neverland January 30, 2016, 3:35 pm

    @plantingacorns

    They use seino weibo in China so since 20% of the world’s population live there what’s app won’t take over the world

    If I had a £ for every technology company that was going to take over the world I would be a multimillionaire by now

    In other news Friends Reunited shut down last month…

  • 17 Neverland January 30, 2016, 3:37 pm

    @ Justin

    Just as equally we could have civil war in a major oil producer like Saudi Arabia, Nigeria or Venezuela

    If the collapse in the price of gold and oil should tell us anything it’s that the future is unknowable

  • 18 Planting Acorns January 30, 2016, 3:45 pm

    @Stella – it definitely will be interesting.

    @Neverland … Friends Reunited had 900 million active monthly users? Wow.

  • 19 Planting Acorns January 30, 2016, 3:48 pm

    @Justin… With regards frackers this looks interesting…they go bust, the lenders suffer the losses, then a big fish buys the assets/ management at a song and reaps the benefits… I’m still for passive investing though, too many what ifs to risk my future on ;0)

  • 20 StellaR January 30, 2016, 4:03 pm

    Neverland – good point about possibility of a sterling run – perhaps nothing is truly safe, as I’m effectively betting that the government can be trusted! Most of my equity holdings are not in sterling though, which may turn out of be a good thing in that scenario.

  • 21 helfordpirate January 30, 2016, 4:28 pm

    I have a 8% allocation to commodity futures (via CRNL and CRBL). It has obviously been an ugly time to hold this asset class!

    My rationale (after reading the long running debate between Ferri and Swedroe in the US) was that, as historically CCF have been not well correlated to equities and even less so to bonds, that the diversification effect would reduce the volatility of the portfolio (but also reduce the return). For someone approaching de-accumulation this should mean one could hold more equities and also longer duration bonds (I have a large allocation to linkers) while reducing the risk your portfolio get’s caned just prior to drawing from it.

    I also wanted to own “lean hogs”! (Or at least an option on one!)

    So your Morningstar quote is a bit disconcerting i.e. it shows reduced return but also slightly increased volatility/risk and so poorer Sharpe ratio. I guess Swedroe would argue that by adding commodities you would also need to adjust your remaining portfolio to perhaps increase equities and longer duration bonds.

    At the moment, I feel Ferri’s simple response of “if you want less of the volatility of equities, it’s easier just to hold less of them” sounds attractive!

    But now is not the time to revisit asset allocations.

  • 22 Naeclue January 30, 2016, 7:49 pm

    The problem is not so much that commodities generate no income, it is that it actually costs money to hold them. Commodity futures are in contango most of the time and physical commodities have to be stored, guarded and insured.

    It is not necessary for an investment to produce an income for it to be an attractive investment (e.g. Berkshire Hathaway), but I like investments to have some kind of process that produces an expected positive internal rate of return. That positive expected IRR means that the longer the investment is held, the more likely it will be that I can achieve a profit. Property, bonds, shares and even cash deposits all have positive expected IRRs. Commodities, along with precious metals and “collectibles”, do not.

    The only way to make any money out of a physical commodity is if someone is prepared to pay a higher price for it in the future than today’s price + storage costs. That might happen, but I have absolutely no clue whether it will or will not and as we have seen, volatility can be huge. Not the kind of investment that has ever interested me.

  • 23 Neverland January 31, 2016, 12:42 pm

    @Naeclue

    “The problem is not so much that commodities generate no income, it is that it actually costs money to hold them. Commodity futures are in contango most of the time and physical commodities have to be stored, guarded and insured”

    Yes thats totally correct

    Now there are a lot more assets with negative yields; some government bonds; flats in London; etc.

    Therefore the lost income from holding commodities is much less

  • 24 theRhino January 31, 2016, 1:51 pm

    saw the big short – it was very entertaining – a recommend for sure

  • 25 Naeclue January 31, 2016, 2:11 pm

    “Now there are a lot more assets with negative yields; some government bonds; flats in London; etc.

    Therefore the lost income from holding commodities is much less”

    Much less than what?

    The fact that I may lose money by investing in other things does not really sell the investment case for commodities to me 😉

    I invest in gilts and (inside my SIPP) US Treasuries. They both have positive yields. If/when yields go negative I am not sure what I would do.

    Flats in London on negative yields? How is that possible? If you mean rental income is less than costs, including funding costs, then yes I suppose there could be some flats like that. Sounds a dangerous sort of game to me and again not something I would want to get involved with. However similar to investment in zero yield high growth companies, the investment case might be one based on the assumption that even if a flat has a negative yield now, over a prolonged period it is anticipated that the yield will become positive because the rental income will eventually overtake the holding costs. In that case, the capital value should also be expected to rise. With commodities, no matter how long you hold them, they will always have a negative yield and so realisable profits can only come about through supply/demand pushing up the price.

  • 26 helfordpirate January 31, 2016, 2:53 pm

    @Neverland @Naeclue
    I think the academic argument for commodity futures as an asset class is based on their diversification benefit rather than their return per se. Increasing the diversification with commodities is supposed to improve the risk/return ratio – you can either take this as more return for the same risk, or same return for less risk.

    Unlike commodities e.g gold or oil, commodity futures do have a potential return beyond the movement in the spot price (which you would think would mean-revert to inflation): a roll return depending on whether the market is in backwardation or contango; and collateral return on the collateral posted on the futures contracts (usually US bonds I think). (Assuming your ETF tracks a “total return” index.)

    Not much and not reliable I grant you!

  • 27 amber tree January 31, 2016, 3:35 pm

    Hey Investor,

    Thx for your insight via this article. It is refreshing to see the performance of the commodities throughout the years.

    I have learned the hard way that investing in oil stock when they are down 20 pct means nothing… They can go down even further. The real driver is the oil price and that is in the hands of speculators and nations that have a political agenda. Anyway, It was a good lesson for me. It happened in my play portfolio, and in a way that is the intent… I count on a recovery one day, the paper loss is manageable for me.

    As for physical gold trackers, I have them as an insurance… I pay premiums now (paper loss on my investment) in the hopes for a big pay out when I file a claim (major financial trust crisis like in 2008)

    With my experience so far, I now sit back and wait for the results. It is part of my learning curve.

  • 28 Neverland January 31, 2016, 4:52 pm

    @naeclue, Helford pirate

    I was just reading the FT market section this afternoon: half of all bonds issued by European governments now have negative yields

    The one aspect of physical commodities that appeals to me is that they are not subject to government manipulation (or to be more precise not by the same governments as gilts or treasuries)

    So yes the argument I would put forward is diversification

    In this respect I have joined the moneyweek crowd

    I really do think with rates bumping around at 300 year lows it is quite different from the recent past

  • 29 WhiteSheep January 31, 2016, 6:45 pm

    @Gregory Yes, I am long in physical gold and titanium and pay no holding costs. Instead of a broker I have used dentists and an orthopedic surgeon – both professions are much more tightly regulated. Annual rebalancing is painful though.

  • 30 The Investor January 31, 2016, 6:58 pm

    I think it’s possible that this is a particular/opportune moment regarding investing in commodities, for the reasons @neverland states and also the fact that many are priced at multi-year lows (nb: though in most cases not multi-decade lows) and that given they’re broadly cyclical, you might expect an upswing eventually.

    (It’s equally possible it’s not; I mean I think the argument can be made and credibly entertained).

    However for me that means they *might* be an astute limited duration active investing decision/purchase/trade presently, rather than it being an argument to say they should be part of a passive investors’ ongoing set allocations.

    As TA says, the risk/reward evidence to-date seems to imply they’re not worth it. They add risk that’s not rewarded.

    The holding costs / negative roll issues with futures is another downside, as has been discussed.

    Finally, we all hopefully understand the inherent ridiculousness of a bunch of amateur investors saying they know better than the multi-billion dollar commodity funds out there. Or at least we have to believe we have a set of constraints that is different from them (i.e. another way to win).

    Time arbitrage might normally be one (a private investor can buy and hold through further pain, say, whereas that would be unacceptable to a commodity fund’s investors, perhaps). But when it comes to time arbitrage, with commodities we’re back to holding cost / technical issues.

    Eventually these roads of thought do tend to bring you back to a long-term small percentage allocation to gold, which can easily be held in size at reasonable cost in physical form, which was one reason I shared my investigations into how gold is taxed a few months ago.

  • 31 Neverland February 1, 2016, 9:49 am

    @Investor = Goldbug

    Welcome to the dark side – we have cookies…

    …and anyway LTCM was run by Nobel prize winners but still turned out to be not really very long term

  • 32 Gregory February 1, 2016, 5:20 pm

    @WhiteSheep You are precious:)

  • 33 Financial Samurai February 1, 2016, 9:15 pm

    Excellent explanation. Be careful with association because there are derivative reasons for why an asset class will move that is hard to pinpoint.

    Also look up “The Bullwhip Effect”

  • 34 theFIREstarter February 2, 2016, 10:47 am

    I have a friend who works for a commodities fund and he has had a very interesting January, to say the least (not that I’ve been able to see him to talk to him much about it, 11pm finishes most nights by the sounds of it!)

    Funny to see the article on Topps Tiles… I’m off there now to buy some more flooring for the kitchen, I love the place but mainly because you can change up Tesco vouchers at 3x the voucher rate… Kerchingggg!!! 🙂

  • 35 The Investor February 2, 2016, 9:03 pm

    @Sam — The Bullwhip affect is a new term to me, and interesting!

    From Wikipedia:

    The bullwhip effect was named for the way the amplitude of a whip increases down its length. The further from the originating signal, the greater the distortion of the wave pattern. In a similar manner, forecast accuracy decreases as move upstream along the supply chain. For example, many consumer goods have fairly consistent consumption at retail. But this signal becomes more chaotic and unpredictable as you move away from consumer purchasing behavior.

    This bit is priceless! 🙂

    In the 1990s, Hau Lee, a Professor of Engineering and Management Science at Stanford University, helped incorporate the concept into supply chain vernacular using a story about Volvo.

    Suffering a glut in green cars, sales and marketing developed a program to move the excess inventory. While successful in generating the desired market pull, manufacturing didn’t know about the promotional plans. Instead, they read the increase in sales as an indication of growing demand for green cars and ramped up production.

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