Commodity Futures not the same as Commodities
Recently, Canadian Capitalist asked whether Canadians should add commodities to their portfolios. On the surface, I couldn’t understand why a hunk of copper would be expected to perform as well as the stock market. However, when we say “commodities”, we are actually referring to commodity futures. (No doubt Canadian Capitalist understands this well.) Futures differ from the commodities themselves in important ways.
There is no reason to believe that commodity futures will give the same returns as the commodities themselves. When we buy a copper future, the price will reflect not only the current price of copper, but also the uncertainty in the future value of copper. Like any other derivative, commodity futures have time value.
If an investor buys a one-year copper future, sells it a year later, and buys another one-year copper future, there is no reason to believe that the sale price of the first future will match the purchase price of the second future. However, actual copper will maintain constant value during the few seconds the investor was making the futures trades.
I’m convinced that owning commodities directly is unlikely to beat investing in the stock market. After all, we keep getting better at growing things and digging things out of the ground more cheaply. A possible exception is commodities that are being exhausted, like oil.
However, commodity futures could easily perform very differently from the commodities themselves. The price of a future will reflect a risk premium. The more perceived risk, the greater the expected return. None of this proves that commodities futures are a good investment, but it is possible.
There is no reason to believe that commodity futures will give the same returns as the commodities themselves. When we buy a copper future, the price will reflect not only the current price of copper, but also the uncertainty in the future value of copper. Like any other derivative, commodity futures have time value.
If an investor buys a one-year copper future, sells it a year later, and buys another one-year copper future, there is no reason to believe that the sale price of the first future will match the purchase price of the second future. However, actual copper will maintain constant value during the few seconds the investor was making the futures trades.
I’m convinced that owning commodities directly is unlikely to beat investing in the stock market. After all, we keep getting better at growing things and digging things out of the ground more cheaply. A possible exception is commodities that are being exhausted, like oil.
However, commodity futures could easily perform very differently from the commodities themselves. The price of a future will reflect a risk premium. The more perceived risk, the greater the expected return. None of this proves that commodities futures are a good investment, but it is possible.
@CC: The clarification was mostly for my own benefit. I'm not sure if others had the same confusion I did. I had dismissed commodities because I couldn't see how they could beat or match stocks over the long run. However, futures are a different matter. I'm not rushing out to buy, but it seems that some investigation is warranted.
ReplyDeleteThe comment above is a reply to Canadian Capitalist's comment:
DeleteIt appears that a commodity index tracking spot prices does not exist (or I'm not aware of it). Even if it did, it may not be investable. The exceptions are some of the precious metal ETFs that hold bullion in a vault somewhere. Thanks for the mention and the clarification.
@Larry: You make a good point. I saw where you were going with new investors possibly lowering expected future returns, but the possible change in correlation with stocks is an excellent insight I didn't see coming. Unless this correlation stays negative (or at least low), there is little benefit to diversifying unless commodity futures actually have higher expected returns than stocks.
ReplyDeleteThe comment above is a reply to Larry MacDonald's comment:
DeleteMJ
Perhaps another problem is that the pro-commodity research Stephensen refers to (as mentioned on Canadian Capitalist's blog) has been public since 2004-2005. In response, investment managers have already moved huge sums into the “new asset class” of commodities. Commodity index funds have also allowed retail investors to do the same. The influx of these new kinds of investors (with different motives)has altered commodity markets. They are now subject to forces different from those in the periods covered by the studies. So I wouldn’t necessarily expect them to behave or perform according to the study’s findings -- i.e to remain uncorrelated to stocks while providing similar or better returns than stocks.
What about investing in art or cars, aren't those considered commodities?
ReplyDelete@Jenna: Depending on how far you're willing to stretch the definition, cars and art are sort of like commodities. They're really more like collectibles.
ReplyDeleteAnother way to invest in commodities is through businesses that extract them (ie, the TSX). That's a different story since they are actual businesses that have a valid reason to give you a return over time, and they are affected by the value of the commodities which may be negatively correlated with stocks. Of course as CC points out that's just about effortless for anyone in Canada :)
ReplyDelete@Richard: Investing in businesses that extract commodities may be good advice, but they are likely to perform differently from investing in commodity futures.
ReplyDeleteThat's what I would hope - they are still business stocks so they're not pure speculation (as long as they actually own some claims to resources) but their potential profits increase when other businesses are in trouble and commodities become more valuable. Of course being business stocks that are affected by the same factors as others (such as interest rates) might lessen their diversification factor, but investing in something unproductive is hard for me to see.
ReplyDelete