May 15, 2011

Reconsidering the Case for Commodities

One investment firm contends that the fundamental case for commodities has changed since the late 1990s

Almost every advisor with whom I speak recommends that clients’ portfolios have some exposure to commodities. The specific allocation varies with the usual factors: funds available, risk tolerance, time horizon, etc. The format varies, as well—some advisors recommend owing physical assets, like gold and silver coins, while the majority prefers financial instruments like ETFs and mutual funds.

The advice to include commodities may be ubiquitous, but it’s been difficult to find advisors who can cite a quantitative justification for their recommendation. When I ask about the portfolio research and analytics—published or internal—they use to justify commodities’ role, most advisors cite the standard qualitative arguments such as increased diversification, inflation protection, and so on. Very few can point to recent research that supports commodities’ role in clients’ portfolios.

RS Investments, a San Francisco-based investment management and research firm, provides a welcome quantitative analysis in their spring 2011 white paper, “Real Asset Strategies: Commodities vs. Natural Resource Equities.”

The firm contends that the fundamental case for commodities has changed since the late 1990s. Underinvestment in supply combined with increased demand from developing countries to significantly reduce many commodities’ spare capacity.

At the same time, the marginal cost of supply for most commodities began to increase. Consequently, RS Investments forecasts that “Future (supply) projects will require higher prices to generate economic returns, meaning that the incentive price needed for incremental production to meet incremental demand will continue to increase.”

From a long-term perspective, commodities have had negative or low correlations with other asset classes. That benefit has been reduced in recent years, according to RS Investments. For example, the correlation between the S&P GSCI and the MSCI World Index–All Markets is 0.28 for the trailing 20 years (through 12/31/2010). But that correlation increases to 0.50 for the last seven years and 0.6 for the past five years. The correlations have become even higher during down equity markets: 0.61 over seven years and 0.64 over five years.

The RS research also questions commodities’ inflation-protection benefits. One factor cited in the study: shifts in futures curves.

“In addition, the inflation protection characteristics of commodities have been negatively impacted by shifts in the futures curves over the last 10 years,” write the investment firm. “Specifically, the negative roll yield caused by the futures curves being in contango more frequently than in the past has offset 75% of the returns generated by spot prices between 2001 and 2010. We contend that the shift in the futures curve is related to the improvement in underlying fundamentals for most commodities. In particular, limited spare capacity and rising marginal cost of supply should lead to futures curves discounting higher long-term commodity prices more frequently.”

RS Investments, which manages a natural-resource equities fund, argues that those stocks have become a preferred alternative to commodity investments. Their research indicates that natural-resource equities, as measured by several indexes and their own fund, have provided higher returns, comparable longer-term inflation protection, and greater portfolio enhancement. Here’s the firm’s key proposition:

“When comparing the potential returns generated by commodities with those of natural resource equities it is important to recognize that commodities themselves do not create value – they simply fluctuate in price. However, natural resource equity strategies offer investors two unique sources of return: 1) the ability to invest in companies that create value independent of commodity prices, and 2) the ability to gain exposure to commodities that are not traded on futures exchanges and are not typically owned in diversified equity portfolios.

Natural resource companies with low-cost advantaged assets can create value irrespective of changes in commodity prices because of their positions on the supply cost curve. This value compounds over time to the benefit of the long-term investor. While natural resource stocks may go up and down with movements in the underlying commodity price over short periods of time, they track changes in net asset value over longer periods of time. As a result, share prices can materially outperform commodity prices for those advantaged natural resource companies with low cost assets that consistently grow net asset value across a commodity price cycle. The ability of a natural resource company to create value is a key point of differentiation between commodities and natural resource stocks.”

RS Investments obviously has an interest in promoting their natural resource fund. Nonetheless, the firm’s research builds a quantitative case for considering an alternative to commodities. The white paper is available online (to advisors who register).

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