The Trouble with Tactics

Should investors allocate a portion of their portfolios to commodity futures?

Much research has shown that commodity futures are a more reliable diversifier than other asset classes. In a recent article, I noted a case where they did not avail, and suggested advisors consider the possibility that a newer crop of commodity trends funds might hold an advantage over their commodity futures cousins.

So it is with great interest that I encountered a new study investigating the benefits of commodity futures in a portfolio in the Journal of Investing.

In the piece, authors C. Mitchell Conover , Gerald R. Jensen , Robert R. Johnson and Jeffrey M. Mercer confirm that adding commodities to an equity portfolio improve both risk and return. Their key insight however is that the monetary environment into which one invests significantly affects returns.

The authors compare portfolio effects of commodities against decisions by the U.S. Federal Reserve to raise or lower its discount rate. While commodities lowerrisk in both interest rate environments, the direction of U.S. interest rates have opposite return effects.

Specifically, a rising rate environment (consonant with Fed worries about inflation) boosts commodity returns (thus demonstrating that commodities do indeed act as a hedge against inflation), whereas a declining discount rate coincides with reduced returns. The annual return effect is 2.4% in either direction.

The authors recommend a tactical asset allocation strategy, scooping up commodities as interest rates rise—when worries about inflation would strengthen returns—but not adding to the allocation in a declining rate environment,.

The idea is breathtakingly easy to implement, given the observable signal of the Fed discount rate. But I believe the idea falls prey to the inherent pitfalls of any tactical approach, which tends to work less well prospectively as it does retrospectively.

This is because an idea’s predictive power decays rapidly in a market where knowledge is widely diffused. A buyer expecting something worth $10 to soon be worth $12 will not be able to get a seller to part with it at the lower price (since the item’s owner also expects it to rise in value).

This “prediction paradox,” cited by Fairmark’s Kaye Thomas, among others, is perhaps most famously demonstrated by the classic “Dogs of the Dow” tactic.

Many investors easily grasped the fact that each year’s lowest-performing Dow stocks were typically the result of market overreaction. Buying each year’s “dogs” resulted in commensurate outperformance for many years—until the strategy became too well known to become effective.

Maybe this just-published tactical allocation strategy has got a little life in it. But the study’s most valuable conclusion is its confirmation that an allocation to commodities reduces risk and enhances returns over time.

Reprints Discuss this story
This is where the comments go.