Morningstar Advisor - December/January 2010 - 40

Spotlight Commodities Are a Rock in a Hard Place By Paul Justice As the asset class has become more popular, its diversification benefits have faded. The rise and fall of commodities as a diversification tool for the masses may have been quick. Just two decades ago, only a select few investors viewed commodities as an asset class. Then came academic research into the returns of commodity futures that argued persuasively for their diversification qualities, and over the past 10 years, new indexes opened the category to scores of individual investors for the first time. This movement only recently surrendered some ground, thanks to the crisis of 2008, when commodity futures crashed along with every other asset class. While it is well known that the correlation of returns to historically uncorrelated assets goes to one amid a deleveraging crisis, the rising interest in commodity investing itself appears to be diminishing the asset class’ viability as a portfolio diversifier. Nature of Commodities returns for commodity investments because of price increases. This may or may not prove true, but what is often overlooked is that price return will come without the benefit of interest income or dividends that traditional investments in equities and bonds provide. In the short term, commodity price volatility will reflect the availability of above-ground supplies and the flexibility of producers to increase or decrease production relative to demand. Except for the unique case of precious metals, commodity inventories are typically scant compared with annual production, and resource producers have difficulty adjusting production in a meaningful capacity. That’s the nature of commodities, and it leads to volatile returns. Pool Grows Larger First, as investment dollars reach critical mass within any asset class, the asset class itself begins acting like other financial instruments. Its return profile becomes correlated to the capital markets cycle. In the not-too-distant past, portfolio managers and individuals used to trade mainly in equities and bonds. An entirely separate set of farmers, energy producers, and mercantile-exchange arbitragers dominated the commodities markets. Today, many more portfolio managers engage in commodity speculation, especially through the futures market, tying capital flows in commodities to those of the bond and equity markets. In fact, the monthly financial activity in the commodity space is considerably larger than the physical production, and that imbalance has grown rapidly over the past several years. Second, most investors use futures to invest in commodities rather than owning the physical asset directly. Physical storage carries prohibitive costs for most commodities, forcing most financial investors to use futures and leaving the spot market prices to producers and major consumers. The futures investment strategy does have some flaws, however. As futures contracts near expiration, commodity funds have to roll those contracts to the next month’s contract to avoid taking ownership of the physical commodity. The catch is that the futures curve—that is, the prices of Almost as certain as the characteristics of commodities spot markets will not change, it looks like the practice of investing in commodities futures has changed permanently. The advent of commodity exchange-traded funds expanded financial investment in commodities from the few foundations and pensions that invested in the early futures indexes to an enormous pool of individual and institutional investors worldwide. This influx had substantial consequences for the returns on those investments. Certain characteristics about commodities will never change. First and foremost, commodities are non-earning assets; they do not produce any wealth of their own, so long-term prices will correlate closely to the marginal cost of production. Many speculate that rising global demand and increasingly scarce resources will lead to high 40 Morningstar Advisor December/January 2010

Morningstar Advisor - December/January 2010

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