When fund providers make the case for investing in commodities, one of the most frequently cited selling points is that they provide a source of non-correlated returns for traditional portfolios.
Unfortunately, that claim doesn’t stand up to scrutiny.
Given that commodities actually have had an exceptionally high correlation with stocks — as well as a dismal risk-return profile — in recent years, investors might want to think twice before piling their money into commodities.
Commodities: No Longer a Source of Diversification
While commodities were indeed a source of diversification in the past, that hasn’t been the case in the past four years.
Since the post-crisis low of March 2009, the PowerShares DB Commodity Index Tracking Fund (NYSE:DBC) has a correlation of 0.77 — with 1.0 being perfectly correlated and -1.0 being inversely correlated — with the S&P 500 Index and 0.81 with the Vanguard Total World Stock ETF (NYSE:VT), which is invested in U.S., developed market international and emerging-market stocks.
These correlation numbers indicate that commodities have provided almost no diversification benefit relative to stocks, representing a shift from the norm that used to exist between the asset classes.
Not that many years ago, commodities were traded almost entirely by commercial hedgers and specialized futures traders. But today, funds and ETFs have provided access to the commodities market for a much wider range of investors. The result is that commodities now trade as a financial asset — largely because that’s precisely what ETFs such as DBC and iShares GSCI Commodity-Indexed Trust (NYSE:GSG) are.
A prime example of the influence of ETFs on the commodity markets occurred with gold in the past four years. Just as the huge demand for SPDR Gold Trust (NYSE:GLD) helped drive up the price of gold in 2011, so too did the liquidation of the ETF contribute to the selloff in physical gold last month.
The result: commodities have become as sensitive to the risk-on/risk-off shifts in the market as stocks, high-yield bonds or any other risk asset.
With this as background, don’t be fooled by fund companies that make the case for commodities by using longer-term correlation numbers. Today’s market is affected by factors that simply weren’t in place until just a few years ago.
Dismal Recent Returns for Commodity Funds
The lack of diversification hasn’t been the only problem. Commodities also have dampened returns for anyone who allocated a portion of their portfolio to the asset class in recent years.
Since the post-crisis low, DBC has generated an average annual total return of 8.1%, well behind the 25.9% return of the SPDR S&P 500 ETF (NYSE:SPY) during that time. And since its inception on Feb. 6, 2006, DBC has posted an average annual total return of 2.1% vs. 5.7% for SPY.
One reason for this shortfall is the impact of dividends. While stock funds pay dividends and enable participation in the earnings stream of the underlying companies, commodities are non-productive assets that fail to provide either benefit. Further, many passively managed commodity funds (although not DBC) actually destroy wealth over time by perpetually rolling from the near-month contract to more expensive, longer-dated contracts.
Here, a skeptic will note that the time periods cited above were times of low inflation, and that commodities would have a better showing if inflation had been higher. True enough, but stocks also have been an effective inflation hedge over the long-term.
Wharton professor Jeremy Siegel, in an article published in Kiplinger in 2011, wrote:
“Nearly all the inflation that the U.S. has experienced during its history has occurred since the end of World War II. The price level, as measured by the consumer price index, has risen tenfold since January 1947. Meanwhile, Standard & Poor’s 500-stock index, which was valued at 15.66 in January 1947, was 1328 in early April 2011 — about 90 times higher.”
Stocks indeed have lagged commodities during periods of high inflation (5% or more), but that’s an extremely unlikely scenario in current economic conditions.
Plus, a Rocky Road
Finally, commodities have been more volatile than equities over time. According to Invesco, the five-year volatility measures for three major commodity indices were all substantially higher than that of the S&P 500:
|Index||Volatility, Five Years through 3/31|
|DB Commodity Index||23.50%|
|S&P GSCI Commodity Index||27.04%|
|DJ-UBS Commodity Index||21.03%|
|S&P 500 Index||18.92%|
This means investors in commodity funds have not only been earning lower returns, but they have been doing so with higher risk.
The Bottom Line
In short, commodities produce lower returns and higher volatility than equities, while generating no dividends and demonstrating higher correlations. Thus, investors would be better served by simply holding stocks rather than allocating any part of their portfolios to commodity funds.
As of this writing, Daniel Putnam did not hold a position in any of the aforementioned securities.