Of all the asset classes available to investors, commodities are probably the least understood. That’s not surprising, because most financial content centers around stocks and bonds. Commodity markets are strange and exotic by comparison.
Commodity ETFs differ from equities in one very substantial way. Equities are expected, over time, to appreciate. The idea is that stock prices tend to follow earnings, and earnings generally appreciate over the long term.
This expectation contrasts with, say, a casino, where the expectation for the gambler is negative over time. The house will always win in the long run, although gamblers may experience brief periods of positive return.
Commodities are more like a casino, but not because they are subject strictly to chance. Commodities (and therefore, commodity ETFs) are subject to demand, and happen to be extremely sensitive to even small changes in that demand.
The result is that most commodities experience high volatility, and may even deliver outsized returns or losses in the short term, but over the long term, they are equally unpredictable.
Heck, just look at this chart of iPath Bloomberg Cocoa SubTR ETN (NIB). It’s all over the place for the last seven years, and down 15% overall. Sure, you’re happy if you shorted in February 2011, and went long a few months later, but as a buy-and-hold investment, you’d have done better in a money market fund than commodity ETFs like this.
That’s pretty much the case for all commodities, and commodity ETFs.
Consequently, commodity ETFs serve no real purpose in a long-term diversified portfolio. One might argue that, with interest rates so low on fixed investments, that commodity ETFs make sense as a replacement for those investments. I disagree, because commodity ETFs volatility will keep you up at night, whereas preferred stocks offer little volatility and far exceed the yields of bonds.
The Right Time to Use Commodity ETFs
So is there a right time to add commodity ETFs to your portfolio? There are probably two periods when that strategy might make sense.
The first period is at the end of a huge economic crisis. Things are looking bad, there’s blood in the streets, and people think the world will never recover. But it will — and when it does, demand for commodities and commodity ETFs will increase. So I might buy commodity ETFs to fill 3% of my portfolio.
If you ever go with this strategy, just know that you’ll need to be quick on the sell trigger. As we saw after the financial crisis, commodity ETFs topped quite some time ago.
The other period commodity ETFs make sense is when inflation looks certain. Because inflation erodes the value of money, anything that is an actual hard asset becomes more valuable.
Any other advice on commodity ETFs? Well, yes, I have two other thoughts. If you insist on holding commodity ETFs, and have decided you’d rather do that than blow all your cash in Vegas, then buy Teucrium Corn ETF (CORN). Corn is the key to feeding people around the world. There will always be some kind of demand for countries suffering from famine. Corn is also being used as an additive to so many types of food.
Otherwise, you might expect me to suggest buying oil, via the PowerShares DB Oil Fund (DBO). Instead, however, I suggest you go with The Energy Select Sector SPDR Fund (XLE). Rather than simply be tied to the price of oil, you are buying into companies that take oil and make it into gasoline and other fuels, i.e. companies where the stock price follows earnings.
But the bottom line here is that commodity ETFs are usually best avoided.
Lawrence Meyers is the CEO of PDL Capital, a specialty lender focusing on consumer finance. As of this writing, he was long XLE. He has 20 years’ experience in the stock market, and has written more than 1,200 articles on investing. He also is the Manager of the forthcoming Liberty Portfolio. Lawrence Meyers can be reached at TheLibertyPortfolio@gmail.com.
