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Commodity ETFs are Dying and that’s a Good Thing

One of the points I stress in my book is how commodities are not really a wise asset class to allocate assets to for long periods of time.  History has shown us that commodities generate poor real, real returns over the long-term.  But we don’t have only history on our side.  It makes perfect sense that commodities aren’t good long-term performers because they’re huge cost inputs in the capital structure.  So they tend to have a very high correlation with inflation.

It’s interesting to look at commodity trading exchanges where these financial products were created primarily as hedging products and slowly became trading vehicles.  As a hedging vehicle commodities often make a lot of sense.  But as a long-term allocation they make no sense.

It’s my opinion that commodity investing has become somewhat of a fad.  As some people have tried to add forms of diversification to portfolios to add some non-correlation they’ve tilted towards commodities.  This became a hot selling idea for Wall Street firms who could create products that invested in commodities.  And in my opinion, the foundation of this thinking was never very sound as it made no sense to allocate assets towards commodities in the first place.

Anyhow, we’re now seeing a massive supply glut in commodity ETFs and so the death of the commodity ETF has begun.  That’s a good thing.  Commodities in a portfolio are often diworsification.  That is, there’s a level where adding too many assets and trying to get too fancy can be detrimental.  I hope retail investors begin to shun commodity ETFs en masse.  That way hey’ll be transferring a lot less of their money into the pockets of financial engineers.

14 comments
  1. Avatar
    Mary

    I think commodities have a place over (shorter?) periods of time; like stocks or bonds, -it needs a strategy and tactical approach. I use them for some balancing of certain risks. They are never close to the largest position in the port.

    Commodities are subject to historical/long term/secular trends like any other asset class. Prof. D. H. Fisher (I think) made an interesting quote that I recall: “technology defines the value of a commodity”. What that means is that commodities go in and out of favor. I think whale oil was a global commodity prior to 1900, but now might be somewhat illegal (I’m not a whale oil expert).

    Dino/crude oil is cycling as well. While there may be “excellent” demand for it, many developed economies have gotten MUCH more efficient with respect to BTU/GDP. If the rest of the world does that, lots of the extrapolations of future oil demand will be very wrong.

    And so it goes. It’s hard to “buy and hold” a single commodity, for sure. A fund of diversified commodities makes more sense, but that too, is tricky.

    None of this stuff is “buy it and forget it” investing.

  2. Avatar
    jaymaster

    I agree. I own an oil ETF as a hedge for my winter heating bills, but I don’t consider it an investment.

  3. Avatar
    Aaron

    CTAs don’t buy and hold commodities… Most of them are trend following in nature and trade not just commodities but stocks, bonds and currencies too.

  4. Avatar
    John Daschbach

    Commodities, in macro economics, are all physical manifestations of stored productivity. Often the composition of any commodity has a large component of natural stored productivity humans harvested (lumber, oil, …) but to someone who understands macro economics commodities are everything physical, from oil to washing machines. The aggregate global store of commodities is one of two parts in real macro economic productivity, human productivity minus consumption of past productivity (commodities). Detailed balance over the long term requires that the real return on the aggregate global commodity store is equal to the real return on human productivity.

    So the idea that commodity investing is a fad is only put forth by someone who doesn’t understand macro economics. If you could buy a global aggregate commodity portfolio and a global aggregate financial asset portfolio, they have to be equal in the long time limit. This is trivial macro economics, which one can derive with one simple differential equation. Once again Cullen, you show your inability to understand macro economics and the mathematics which describes it.

  5. Avatar
    Materials Risk

    I’d be interested to know what evidence you refer to in your book to say that commodities are not worthwhile over the long term. The main research I’ve seen in the area is the 2005 report Facts and Fantasies about Commodity Futures which looked at asset returns between 1959 and 2004 finding a compelling case for including commodities as a diversification tool while also providing relatively high returns vs other assets. Similarly, you make the point in your article that commodities tend to have a high correlation with commodities. But isn’t that one factor in support of holding them?

    https://www.fxvolresearch.com/base/notable/Facts%20and%20Fantasies%20About%20Commodity%20Futures.pdf

  6. Avatar
    Cullen Roche

    You’re not even using the term productivity correctly. You don’t even understand the most basic economic terms yet you continually come here to lecture me. It’s beyond embarrassing.

    Productivity is a measure of production efficiency. Commodities aren’t “stored productivity”. Do you even understand how silly that sounds? You’re trying to say that they’re “stored production”, but because you don’t understand basic economics you make these types of embarrassingly amateurish mistakes. And yet you feel confident in lecturing me….

    Go crack an econ 101 text and stop coming here pretending to be an expert in something you clearly just dabble in over your free time….

  7. Avatar
    tealeaves

    If you correct the commodity returns with “true” CPI data (shadowstats), I bet it looks even better for commodity and inflation bulls 🙂

  8. Avatar
    Andy

    even if an asset class has zero expected real return (such as commodities and most alternative asset classes), if it has low correlation to other asset classes, it can have diversification benefits (lowering portfolio vol relative to portfolio return). estimating future expected return isn’t the only component to constructing a long term portfolio!

    furthermore, commodities are an excellent inflation hedge (you say so yourself “they tend to have a very high correlation with inflation”). isn’t that by itself a good enough reason to have at least a small strategic allocation to commodities? smart instutitional money such as endowments (david swenson) have advocated this for a long time now

  9. Avatar
    Cullen Roche

    I say commodities are trading vehicles if not being used in the production process. The example I use in my book is an airline which can buy fuel contracts to hedge price exposure. Forex is a good example also. It’s a zero sum gain so it’s an obvious poor long-term bet. But you can hedge your exposure to certain things in the near-term. Maybe it’s best to view these sorts of financial products as insurance rather than having them be the core of a portfolio?

  10. Avatar
    John Daschbach

    No, it’s that you don’t understand basic physics and mathematics and you aren’t able to understand the way a scientist views the world and requires that models are based upon physical reality, not your financial world. If you start with the basic requirements of Thermodynamics then it is simple to understand that commodities are equivalent to stored productivity, and that all of the physical world are commodities. Are you familiar with Thermodynamics? Lot’s of what appears to be taught in Econ 101 or any other Econ class or book violates Thermodynamics and is thus worthless. I never bought an Econ text in college and after a couple days never went to class, but I got nearly 100% on all the exams by simply deriving the required mathematics on the fly.

    Humans produce goods and services using physical and intellectual effort. The First Law requires that the production of goods involves the transformation of other goods. By the First Law, everything that exists in the physical world, including “goods” produced with human effort, are at the basic level, macro economically the in the same class. Thus, it’s a logical requirement that if you call one physical thing a commodity all physical things are commodities. This is really simple stuff.

    Almost every commodity in economics involves some measure of human productivity and thus it’s current real economic value includes both the human productivity and the nature created portion. There is no real economic distinction between what you think of as a commodity like oil and a commodity like a washing machine. Are you saying there is a distinction? If you can prove this then you will certainly shortly win a Nobel Prize. Otherwise, it’s you who don’t understand the core of macro economics.

  11. Avatar
    Cullen Roche

    1. You’re still using the word productivity incorrectly.

    2. I never said that commodities like oil were distinctly different from the things they are used to create. You just made that up in your ranting commentary here.

    3. The economy is much more than just real goods. Good luck using math based models to understand that.

  12. Avatar
    Chris Cook

    I probably know more about this subject than most, having been a director of a global energy futures exchange (for instance, I architected the UK’s Balancing Point natural gas futures contract in the mid 90s) and active in the area where markets and internet converge for a decade and a half since then.

    ETFs were not created by commodity exchanges, but initially by investment banks: the Goldman Sachs Commodity Index (GSCI) was the first. Subsequently specialised fund players such as ETF Securities came along.

    The reason they are called exchange traded funds is that ETF shares or units are traded on a recognised exchange like other securities.

    Their relationship with commodity exchanges is that some of them obtain exposure to the relevant commodity market prices through buying commodity futures contracts, which would then be rolled over from month to month.

    Depending on the structure of the market (ie backwardation or contango) they make money (backwardation) or lose money (contango) when rolling over the position, in addition to the losses they incur from the bid/offer spread and exchange commissions.

    Goldman Sachs had the brilliant idea in originating GSCI of selling to investors the concept of ‘inflation hedging’ ie the idea that being exposed to commodities was preferable to being exposed to the dollar. Also ‘portfolio diversification’ served well as marketing bullshit.

    But the presence in the market of what Mike Masters calls ‘passive’ investors – whose motive is not to make a transaction profit, but is rather to avoid loss – gradually changed the very nature of the market itself. Wherever exchange traded funds become dominant in terms of open interest they literally kill price formation in the relevant market.

    In late 2008 – post Lehman – the world and his wife fled into anything but dollars irrespective of whether there was yield or not. These investors were no longer interested in return ON capital – they only looked for return OF capital.

    But by this time, the really smart players had long since realised that there was no need to put trades through exchanges when they could take off market (OTC) positions much more profitably. Because the fact is that a producer, such as BP, who wishes to hedge by offloading oil risk in favour of dollar risk is a perfect match for clients of Goldman Sachs who wish to do the complete opposite (hedge inflation) by offloading dollar risk and taking on oil risk. It is no coincidence that the chairman of BP and Goldman Sachs was the same man for over a decade.

    The joke is that the ‘muppets’ (as Goldman called them) who poured dollars into ETFs were instrumental in creating correlated bubbles, and thereby caused the very inflation they aimed to avoid.

    But eventually, the fears of the inflationistas and gold-bugs proved to be mis-placed and the muppet money has eventually flowed back into the stock market and into any other market offering yield – ANY yield.

    Most of the banks have now wound up their commodity teams who had been pillaging the ETF order flow and monthly roll-overs and this ‘Happy Time’ has now come to an end.

    There is far more to be written – a book, in fact – about what has been probably the greatest market manipulation in market history, which makes Hamanaka’s ten year peccadillo in the copper market look like a car boot sale, but that’s another story.

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