January 2, 2014

Have Commodities Futures Lived Up to Their Promise?

Two recent analyses suggest the previous decade’s hype about high return and low correlation with stocks has not panned out

Whatever happened to the dream of commodities futures? They were supposed to turn the ordinary investor’s portfolios into a sophisticated hedge fund, promising stock-like returns with low correlation to equities.

Many seminal studies purporting to show these benefits, followed by the proliferation of mutual funds and exchange-traded portfolio products targeting retail investors, have popularized the strategy.

But now some thought leaders in the investment blogosphere are starting to pick apart the claims made for commodities futures funds, which generally purchase Treasury securities as collateral for futures contracts in energy, agriculture, livestock, industry and precious metals.

Tadas Viskanta of the popular Abnormal Returns blog initiated the latest round of rethinking. Viskanta hearkened back to the hype of 2006, following a study underscoring commodities futures' equity-like performance but negative correlation to stock and bond returns.

This research, by Gary Gorton and K. Geert Rouwenhorst, was “was picked up by multiple media sources as a major discovery,” Viskanta wrote at the time, commenting now that “new ‘discoveries’ in the financial markets are indeed rare.”

Indeed, Gorton and Rouwenhorst were not alone in thinking this.

A 63-page paper, also written in 2006, by Ibbotson’s Thomas Idzorek and commissioned by PIMCO (which launched one of the first commodities futures funds, and the industry’s biggest) similarly concluded that historical studies and future simulations suggested high risk-adjusted returns for the asset class. (Many other studies, written before and after that time, reached similar conclusions.)

Looking back from today’s vantage point, however, commodities futures have not fared well. The PIMCO Commodity Real Return Strategy Fund (PCRDX) is down more than 12% over the past five years, and down 63% for the decade ending Dec. 31.

PCRDX differs from other such funds in that it invests its collateral in inflation-protected Treasuries, rather than ordinary T-bills, as a means of accentuating its inflation protection.

The inflation that many investors have feared has not come about in the past several years, thus magnifying the pain for PCRDX investors. Those who put their money in the leading commodities futures ETF, the PowerShares DB Commodities Index Tracking Fund (DBC), whose collateral is in short-term Treasuries, fared far better — gaining nearly 16% over the past 5 years (and up 3.55% in the nearly eight years since the fund’s inception); the ETF lost 9% in the past year while PCRDX lost 17.25% in that time.

Viskanta cites current research from UBS projecting high volatility and low returns for the asset class.

That conclusion is in line with the latest blog from Servo Wealth Management’s Eric Nelson, whose latest missive is titled “Somebody’s Making Money Off Commodities but It Ain’t You.”

Nelson, whose analyses tend to peel apart the numbers to isolate causes of investment results, challenges three claims for commodities futures funds.

To the claim that commodities have stock-like returns, Nelson finds that, after teasing out bond collateral returns, “it looks like there might be about a 1% per year return on commodities above the three-month Treasury bill rate, but because the volatility is so high, we really have no idea if that’s the case.”

The Oklahoma City-based investment advisor also shoots down the asset class’s alleged diversification benefits, bringing data to show positive correlation with globally diversified stocks and showing that higher-performing globally diversified bonds offering greater negative correlation with stocks.

The kicker is the miserable year of the global financial meltdown, when one might have hoped that commodities futures would save one’s portfolio. Writes Nelson: “From July of 2008 through February of 2009, a globally diversified all-stock asset class portfolio lost 49% of its value, while commodities lost over 54%!  Short-term, high-quality global bonds, on the other hand, managed to squeeze out a positive 6% return.”

As to the claim that commodities futures hedge inflation, Nelson argues that the asset class is too volatile to do so and argues that TIPS, or even short-term high-quality bonds, perform this role better for inflation-sensitive investors.

So while commodities futures, according to this analysis, fail to perform like stocks, diversify portfolios or protect against inflation, they do perform brilliantly for purveyors of commodities futures products.

Concludes Nelson:

“A back-of-the-envelope calculation puts the annual advisory fees to PIMCO at something north of $16M per year to roll futures contracts, buy a bunch of bonds (as the collateral), and provide exposure to an asset class that probably won’t do any better than a bank CD.  That’s a good job if you can get it!”

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