There are three types of investments in commodities, investing in the physical commodity itself, investing in a derivative instrument, and investing in natural resources stocks. First, we have the physical asset:
- The expected return on the physical asset is roughly inflation, but the historical return on the spot price is actually slightly less than inflation because technological improvements in growing, processing, refining, extracting, etc. have trumped increased scarcity and increased demand over time.
- With the exception of precious metals, it is extremely difficult and/or costly, if not impossible to hold the actual commodity.
- The volatility is extremely high.
- They aren’t a particularly good inflation hedge.
Most investors do not invest directly however, but rather invest in a commodities futures fund:
- Investing in derivatives is a zero sum game. For every winner there must be a loser, and it is irrational to expect to be on the winning side more often than not. On average, the return to all investors will be the return on the collateral (typically Treasury bills).
- The historical out-performance of commodities futures is due to the short history of the relevant indexes, the fortuitous extreme over-weighting of energy in those indexes, and a supply/demand imbalance that caused normal backwardation of the contracts. Currently contango is the norm, turning what has been a historical tailwind for long investors into a current headwind. (I apologize for the technical terminology, but in the interest of brevity the explanation of normal backwardation and contango is outside the scope of this paper.)
- The volatility is about a third higher than the volatility of stocks.
Occasionally investors buy stock in natural resources companies as a proxy for the commodities themselves, but they are a very imperfect proxy because:
- Wise managers of such a company should attempt to reduce their exposure to the commodity with hedging contracts. They seek to profit from skill in their business rather than the vagaries of current market prices.
- Business issues and factors can account for a great deal of their performance (competition, prices of things they need such as supplies and personnel, etc.).
We do not invest in commodities because while it is not “wrong” (particularly in the extremely small doses that are generally used) it is unlikely to be helpful.
While gold is a type of commodity it is popular enough to merit its own details:
- While today’s prices have risen considerably from the recent prices, gold hit $850 per ounce in 1980. If you had purchased gold as an investment at that time, your average annual return since then would have been about 1.23% (source data here). Inflation over that period has been 3.14% (source data here). So an investor would have experienced (so far) 36 years of negative real return. Due to volatility, picking different time periods can give wildly different figures.
- Today, if you are concerned about inflation risk, investing in TIPS (Treasury Inflation-Protected Securities) is a much better option. TIPS are government bonds that pay returns plus inflation. Generally (though not as I write this), the yield on 10-year TIPS is between one and three percent plus whatever inflation occurs.
- In times of financial crisis, gold is less correlated to the market, but so are short-term treasuries. During the 2007-2009 financial crisis, gold was essentially uncorrelated with the stock market, but so were investment-grade bonds, and short term treasuries were negatively correlated, which is actually better.
- Some believe in gold investments as a hedge against some sort of Armageddon scenario. If we have a worst case scenario with no functioning economy, gold will probably be relatively useless as it has little utilitarian value. In other words, if you can’t eat it, wear it, or live in it, why would anyone want it? The best investment for that situation is probably ammunition.
- If we don’t have a financial meltdown, the best gold investment is probably jewelry for someone special in your life. This will probably have a higher rate of return (albeit not a financial one) than buying bullion.
- Finally, some tax trivia. Most folks don’t realize that gold is considered a collectible by the IRS and thus has a maximum tax rate of 28% rather than the capital gains rate of 15% most people would pay – and this is true of investments in ETFs that hold the physical bullion as well.
We do not use gold in portfolios as the low expected return is more detrimental than the diversification potential is helpful.