An article in the Wall Street Journal, “Why Commodity-Index Investing May be Futile” has gotten a lot of interest by investors although there was not any new information in the story. The reasons for avoiding commodity indices should be taken seriously; nevertheless, the broader issue of differences between commodity and equity investing is actually straight-forward. Commodity investing in an index of futures is not the same as a buy and hold strategy for an equity index, yet the factors that make it different are also the reasons for the lower correlation of commodities with traditional investments.
Outlined below are the five reasons for why the WSJ thinks commodity index investing is futile and some elaboration on these differences. Simply put, different users and different markets will lead to different return outcomes.
Is commodity index investing futile?
No, but, a buy and hold strategy during a period of market contango and low economic growth is a loser’s game. The idea that investors should just hold a long-term investment in a commodity index to get a range of commodity exposure has come and gone.
There are a few key issues that have to be answered to be a commodity index investor even in the short-run.
- Where is the global business cycle? – Commodities peak late in the cycle and there generally has to be higher than expected growth to create excess demand for commodities.
- Are there current supply shocks? – Along with strong demand, commodity investing needs to expect or have supply shortfalls for prices to rise.
- Are commodity inventories low? – For unexpected demand or supply shocks to significantly affect prices, commodity markets need to be in a lower than normal inventory environment.
- Are commodity markets in backwardation? – The negative carry from market contango bleeds money for investors. Index investing needs backwardation condition in futures which has not been the case for most of the post Great Recession period.
- Is there higher inflation? – While many have discussed the relationship between commodity investing and inflation, the link has been highly variable. Commodities have not been a reliable inflation hedge over the last ten years. Of course, this has also been a period of deflation or low inflation around the globe. Short-term dynamics and contango will dominate commodity index price moves in a 2% or less inflation world.
Commodity investing should be scenario-driven or situational and not buy and hold. Active management, where variable exposure is held in selected markets, may be a more reliable way of playing commodities. This can be done through sector exposure tilts to energy or agriculture or through active management of individual markets. This can be as simple as holding exposure in markets that show backwardation to some combination of momentum, carry, and fundamentals. Active commodity management is still difficult, so without strong conviction on the efficacy of active management, commodities should not be held as a core portfolio position.