When I was first starting out as an
advisor, one of my regular quips to new clients was to tell them I
needed to know their astrological sign in order to determine what
percentage of their portfolio should be put into pork belly futures. I
figured that anyone who thought I was serious was not going to make a
good client. A few years later, it turned out I WAS serious (about the
futures, not the astrology). For an investor, especially a retiree, it
is important to consider all reasonable ways to reduce the volatility
of a portfolio without substantially reducing expected investment
returns. I have come to the conclusion that commodity futures can play
a valuable role in the portfolio of most of these people.
Historically,
a very common recommendation for widows and orphans was to split their
money equally between stocks and bonds. The idea was that they needed
the growth that could only come from ownership (equity) investments,
but also needed to protect themselves from massive declines, and could
do so by placing some funds in interest-bearing (debt) investments that
were less volatile, at the cost of somewhat lower returns. To see how
that would have worked, consider an investor if they had begun such a
strategy at the start of 1972, and continued it for 35 years until the
end of 2006. Assume also that their stock investment was allocated
equally over the Standard & Poors 500 stocks (a list of large US
companies in all sectors of the economy), and that the remainder was
kept in short-term US Treasury securities. They would have had an
annualized rate of return of 11.4% over that time period, and $10,000
invested at the start of the period would have grown to $436,900
(ignoring expenses). More importantly, if they checked their portfolio
annually, they never would have seen a cumulative loss of more than
11%, which is a pretty modest decline given the excellent growth in the
portfolio. You can see why this was considered a good, reasonably safe
approach for widows and orphans.
Instead, though, let's say they
had split their money between stocks and commodity futures (using the
reasonably balanced Dow Jones AIG Commodity Index). Over those 35
years, their annualized return before expenses would have increased to
12.8%, and $10,000 at the start would have become $686,400, which would
have provided them with over 50% more money than in the stock-bond
allocation. Of course, most people understand that the returns of a
portfolio including commodity futures ought to be larger than one using
short-term Treasuries, because of the much greater risk of the former.
But checking their portfolio annually, the worst cumulative loss was
only 10.2%, slightly SMALLER than the worst loss for the stock/bond
portfolio. Much more wealth with virtually identical downside risk.
(For
those who have seen similar examples with slightly different results in
other writings of mine, please notice that this example is using the
equally-weighted S&P 500, while my other examples used the
traditional, market-weighted S&P 500: I prefer the former for
reasons I discuss in other writings of mine, one of which is that the
downside risk using it is smaller than portfolios that use the latter.
I'm also using short-term Treasuries in this example instead of
Treasury bonds, for the same reason. This article is about improving
safety.)
This is the magic that results from understanding
Modern Portfolio Theory. Combining
different risky assets produces a portfolio with the returns of those
assets but with much less volatility. It is especially useful when the
worst years of each asset tend to be the best years of the other. And
that is a relationship that has historically existed between stocks and
commodity futures. Higher than expected inflation generally has hurt
stocks and helped commodity futures, and lower than expected inflation
generally has helped stocks and hurt commodity futures. Combining the
two investments has, as a result, provided a much smoother ride than
either of the investments separately.
Most people are frightened
when they hear about commodity futures, as they have some vague memory
of it being a really dangerous investment. The first chapter of my
dear friend Andrew Tobias' book THE ONLY INVESTMENT GUIDE YOU'LL EVER
NEED has a story about the danger of commodity futures, along with a
statement that the overwhelming majority of people who invest in them
lose money. This hardly sounds safe or prudent, but the use of
commodity futures described in that chapter is nothing like the use in
the allocation I described above. The example in his book was
equivalent to a bond investor who purchased junk bonds on margin in the
1980s, or a stock investor who bought highly leveraged options on
dot-com stocks in the late 1990s, or a real estate investor who
acquired no-money-down raw land in the current decade. They weren't
hurt by the investment category, but by making undiversified and
heavily leveraged bets in those areas.
Let me start with a brief
example of how commodity futures work. Commodity futures are very
straightforward. Assume a wheat farmer is
trying to obtain protection against a price drop between now and the
date of delivery of the harvested wheat to the marketplace. The farmer
sells a wheat futures contract and the buyer purchases it, with the
contract to be settled at a time near the
expected harvest (I'll pretend it is a year, although actual contracts
are for shorter periods). Since the farmer is, in effect, obtaining
insurance against a decline in the price of wheat, the futures contract
will be at a price that is lower than the expected delivery price of
the wheat (which, by the way, is not the same as the current price).
Let's say the current estimate is that wheat will sell for $7.00 in a
year. The current futures (sounds like jumbo shrimp) price might be
$6.70, and the difference is essentially the cost to the farmer of the
insurance on their livelihood. This means that, assuming wheat actually
is priced at $7.00 when the contract is settled, the buyer will make 30
cents (the farmer will lose the same, but remember that they also will
sell the wheat for $7.00 around the same time to Wonder Bread or
whomever, and will net $6.70). Of course, if the price of the wheat is
only $6.80, the buyer will only make 10 cents, and if the price of
wheat is only $6.50, the buyer will lose 20 cents on the contract (the
farmer will net $6.70 no matter what the price, and that certainty was
the very point of their entering into this contract in the first
place). Of course, if unexpected inflation causes the wheat to be worth $7.50 at
the time of contract settlement, the buyer makes much more than expected (80 cents).
Notice
that the deck is stacked in favor of the buyer of the contract: the
farmer is willing to make a contract at a lower price because it is
insurance to them. Historically, buyers of futures contracts who
didn't use any leverage earned a rate of return similar to that of
insurance company stocks, which makes sense when you consider that the
buyer of a futures contract IS essentially acting as an insurance
company, and should make a rate of return similar to that of others in
the business. What is most important is that the circumstances that
would result in major losses to the buyer (lower commodity prices) is
beneficial to the bulk of businesses, so that combining stocks and
commodity futures in a portfolio appears to be an excellent way to
reduce risk without reducing expected returns. This is why 30% of my
own investable assets are in commodity futures.
The best way for
most people to invest in commodity futures is through a mutual fund
that holds a wide variety of commodity futures contracts.
Diversification is always important, and for an individual to be able
to duplicate the portfolios of most commodity futures funds, they would
need millions of dollars in collateral. I've estimated that it would
take approximately $5 million for an individual to duplicate the
portfolio of the PIMCO Commodity Real Return Fund, which is my current
favorite open-end mutual fund of this type because (1) it uses Treasury
Inflation-Protected Securities as collateral, earning extra returns
above the more typical Treasury Bills, and (2) the Dow Jones AIG
Commodity Index it duplicates is the most balanced of all indexes that
are currently represented by funds, as of the date I'm writing this
piece.
I want to also address some common confusion that arises when I recommend commodity futures as part of a diversified portfolio:
(1)
Commodity futures are not the same as investments in commodities
themselves (such as gold bullion, coins, or trusts). The return on a
commodity will only represent the change in its price, less storage
costs, and this is far lower than the expected return on futures
contracts that are insuring the commodity producer.
(2)
Commodity futures are not the same as investments in businesses that
produce the commodities (such as oil companies). The latter are
affected somewhat by the price of the commodity, but also by general
business conditions (very often prices have risen because of major
production interruptions that hurt the stock) and general stock market
fluctuations.
(3) Commodity futures funds don't end up with the
commodities in actual form. Futures contracts are always settled by
the payment of cash based on the difference between the price index for
the commodity at the settlement date of the contract and the price
index at which the contract is originally struck (my stepfather used to
speculate on pork belly futures in the dangerous manner described in
Andy's book, losing lots of money just as Andy's book said usually
happened, and I occasionally had nightmares of my stepfather forgetting
to close a futures contract in time and having tons of dead pigs dumped
on our front lawn by the seller).
(4) The diversification
benefit of commodity futures is mainly a long-term phenomenon, and it
doesn't generally help much over periods of days and weeks.
Correlation is the extent to which two assets move up and down
together. If they always do so, they have a correlation of +1.00. If
they generally move up and down independently, they have a correlation
of 0. If they always move in opposite directions, they have a negative
correlation of -1.00. On a daily basis, the S&P 500 & Dow
Jones AIG Indexes have had a correlation of around +0.50 with each
other. On a monthly basis, the correlation has been extremely close to
0. Over triannual (3-year) periods it has been -0.40. In fact, with
the longest reliable indexes on commodity futures going back to the
1950s, I cannot find a single 3-year time period in which both US
stocks and commodity futures declined, and suspect it hasn't happened
since the early 1930s, when the Federal Reserve System orchestrated an
insane massive deflation of the money supply that triggered the Great
Depression and that
the current FRS chairman, Ben Bernanke, is virtually certain not
to repeat.
As
for the percentage of a portfolio that belongs in commodity futures,
that depends on several factors, not the least of which is the comfort
of an investor with investments that everybody tells them are risky.
Although my clients trust my judgment, I haven't yet put 30% of the
portfolio of anyone other than myself into commodity futures. Because
the income on these funds is generally taxable each year (unlike stocks
and stock index funds, which can generally postpone capital gains
indefinitely), it is best used in tax-sheltered accounts, and many
people only have tax-sheltered investments in 401(k) plans at work,
which rarely offer commodity futures funds as choices (although that
may change in the near future, given all the academic research in
support of their usefulness). Also, for a younger investor minimizing
volatility is not as important as it is for an older investor, and
dollar cost averaging can make a portfolio consisting entirely of
stocks to be reasonably safe without the extra diversification. Thus,
I am more adamant about using commodity futures for my retiree clients
(which has always struck people as odd, but makes perfect sense if you
understand this article). It is still, in my view, a good idea for
younger investors, but given my earlier comment about 401(k) plans not
offering them, I don't get terribly concerned when a client under the
age of 50 isn't using them yet.
If you understand the potential
usefulness of commodity futures, you will find that even a small
commitment to them can reduce the overall volatility of your personal
investment portfolio. Personally, I think any allocation less than 10%
means taking an unnecessary personal risk, and most of the academic
studies (which you can find all over the Internet with a few
well-chosen Google searches) agree with me. In practice, few advisors
approach the 20% to 25% that I use in many client portfolios (at least
those with large tax-sheltered accounts), but the reason given for not
doing so is often that the clients would resist putting so much into a
category that scares them, or that the advisor doesn't want results
that will vary considerably from the performance of the US stock
market. Personally, I don't mind varying my clients' results from the
US market when the latter is in a free fall, and prefer to rid myself
of clients who complain about commodity futures when they appropriately
drag down a portfolio during a general bull market.
But you're
not my client, are you? So even if this piece (and answers to
questions on my message board) are not enough to convince you to add
this to your portfolio in quantities comparable to those I use for
clients and myself, remember that even a few percent in this category
will be better for diversification than not using it all. At least
think about it, okay?
