Commodities: No Panacea for a Bad Stock Market

October 7, 2009
Richard Ferri

A simple thought experiment demonstrates the long-term yield of commodities. Purchase shares of an S&P index fund, a long-term bond, and a piece of wood, and lock them away for 25 years. Which will be worth more when you finally open the safe?

Commodities have become a hot alternative investment that investors, emboldened by the widespread notion that they are an essential complement to stocks and bonds, have been pouring money into.

The fascination with commodities began a few years ago when it was widely misreported that commodities are negatively correlated with the stock and bond markets and therefore offer protective diversification. Yet this just isn’t the case, and 2008 proved it. U.S. stocks where down about 37 percent and commodities fell about 47 percent.

And this isn’t the first time commodities have failed to save your portfolio. In the fall of 2002, commodities fell with stocks, as they did in 1998 and during many other sharp downturns throughout history. The best that can be said for the commodities is that they let you down at just the time when you need diversification the most.

There is another problem. Over the long term, commodities don’t yield positive returns over inflation. A simple thought experiment can demonstrate this principle. Imagine purchasing shares of an S&P index fund and a long-term bond and putting the documents in a safe. Then imagine buying a piece of wood and putting it in the same safe. Close the safe, come back in 25 years and open it up.

Because of earnings growth and dividend reinvestment, the index fund will probably be worth about three times its original value over inflation, and the bond will be worth about one and one half as much over inflation because of the reinvestment of interest. But the piece of wood will still be a piece of wood and, therefore, worth nothing more than its intrinsic value based on inflation. You will have gained nothing.

Over long time periods, commodities tend to deliver the rate of inflation — which means they provide no real economic return. Worse still, commodity funds and commodity ETFs tend to have substantial fees, so returns might actually be below the inflation rate. The fees for gold funds are further increased by storage and insurance costs.

Commodities’ historical failure to perform for investors in the long term derives from a fundamental difference in their nature. Instead of intrinsic appreciation over time, value from commodities derives from speculating on price increases (or decreases). This value varies with equally unpredictable projections of future supply/demand fluctuations and market hunches.

Professional traders are in an out of a given commodity investment as often as daily and sometimes annually— hardly a long-term investment time horizon. For individual investors, buying commodities is comparable to gambling, not investing.

There’s the secondary argument that a diversified commodities portfolio is a good defensive investment because, even if commodities don’t offer real returns, they are negatively correlated with the stock market. As earlier discussed, in 2008 this was not true, and a close study of market history shows that this instance of correlation was hardly anomalous. Indeed, this positive correlation has manifested over the years at precisely at the wrong time for investors.

Then what’s the source of advice extolling a reliable negative correlation? It comes from focusing on annual averages rather than on specific commodities’ performance within shorter time frames. An examination of individual months reveals periods of positive correlation. These periods are highly critical in an investing arena where money is made or lost from intense trading over short time frames.

Recently, investors have been chasing the price of gold, which is seen as a safe harbor in a financial storm. Not surprisingly, the price of gold is high and rising. Beware. There are several ways to invest in gold, including easy-to-trade exchange-traded funds. This is creating a gold bubble, in my opinion. Gold is currently trading at about $1,050 per ounce. I don’t know how high gold will climb before the correction, but when the price starts falling, it will come down hard and fast.

There’s nothing wrong with individual investors buying a few gold coins as a novelty. But they should be aware that the professionals who are trading up the price of gold are under no illusions that the price will continue to rise indefinitely or on average for the long term. They’re in it for the profits brought by short-term trading, not from long-term investment.

Richard A. Ferri is founder and CEO of Portfolio Solutions, an independent, SEC-registered investment advisory firm offering low-cost, professionally managed investment portfolios. Ferri holds an M.S. in finance and is a Chartered Financial Analyst (CFA). He is the author of The ETF Book, the second edition of which was published this year by John Wiley & Sons.