I recently wrote about how commodities are good for traders, but bad for investors as a useful long-term buy-and-hold financial asset. A broad basket of commodities has given investors lower returns than cash equivalents with higher volatility than stocks.
That higher volatility means there will be cyclical swings where commodities see huge gains as well as huge losses. The question many investors should ask themselves is this: Is there a better way to invest in commodities since the long-term risk-reward profile is so poor?
Commodities are a hedge against much higher inflation, so the past 30 years or so of disinflation haven’t been conducive to strong performance, but there are ways to access commodities in their portfolios without investing directly in futures.
Own an index fund. The simplest way to gain exposure to commodities is to own a broadly diversified index fund. The SPDR S&P 500 ETF currently has around 6% of its holdings in energy stocks and another 3% in basic materials. Foreign stocks have an even higher commodities tilt. The iShares MSCI EAFE ETF has 5% in energy names and 8% in basic materials while the Vanguard FTSE Emerging Markets ETF has 7% and 9%, respectively.
Invest in sector ETFs. You could also invest directly in these sectors. While this is a much more concentrated bet, ETFs now make it easier than ever to make a bet at the sector or industry level.
Boththe SPDR Energy ETF and the SPDR Basic Materials ETF have performed much better than commodities with similar volatility characteristics. The only problem with investing in sector funds is that they still have a fairly high correlation to the overall stock market. The correlations for XLE and XLB to the S&P 500 were 0.62 and 0.88 over this time frame. Many investors put their money into commodities in hopes of finding an uncorrelated portfolio diversifier, which sector funds may not provide.
Invest in companies that mine commodities. Instead of owning the commodities themselves you could simply own equity in the companies that extract them and put them to use. The Vanguard Metals & Mining Fund does just that. Here are the stats in comparison to the S&P 500 and Bloomberg Commodities Index:
This fund had just a 0.05 correlation to the S&P 500 in this time, meaning there is virtually no relationship between the return streams. 1 It also had better returns than commodities, but it did so with much higher volatility. It also comes with bone-crushing losses that can be similar to the underlying commodities.
There have been periods when physical commodities decouple from the equities of the mining companies but both are still quite cyclical. When looking at the types of losses and volatility involved in precious metals and mining stocks it makes for a difficult portfolio holding, even if it ends up providing valuable diversification benefits. Very few investors have the emotional stamina to hold through this type of volatility or rebalance into the pain when necessary.
Stick to trend-following rules. Because of the cyclical nature of commodities they can work much better through the use of trend-following rules. Trend-following as an investment strategy seeks to follow the old maxim that you should allow your winners to run but cut your losers short. The goal of trend-following is to reduce volatility and the potential for large drawdowns.