The round-turn in the commodities market over the past five years has been breathtaking. Take a look at a long-term, monthly chart of the CRB Index below. You can the run-up into the oil price boom of 2008 and the subsequent crash exacerbated by the global financial crisis.
What is interesting to us isn’t the price action, per se. Rather how it is that we got to this place where commodities markets now seem to move in lockstep with the broader financial markets (S&P 500 in gray). A post by Justin Lahart at Real Time Economics prompted this line of thinking on the current state of commodities investing. This was a topic we delved into a great deal when this blog was brand new. However in light of the past few years it is worth revisiting.
Lahart points to a paper (SSRN, pdf) by Tang and Xiong that examines how the many new ways in which investors and speculators alike can invest in commodities has changed their return structure. The rise of indexed commodity investments has changed their underlying return dynamics. In short, commodities now trade more alike with each other and with financial assets generally.
This idea about the financialization of commodities isn’t new, (see Economics of Contempt, Wray). There have been skeptics of the academic case for a commodities risk premium for some time now. Back in 2006 we were discussing the possibility that the new found interest in commodities investing might inflate a commodities bubble.
The interesting question is just how did the commodities equation turn from a profitable, portfolio diversifier into pawns of the broader financial markets? The answer lies in the rising role of speculators and index investors in the commodities markets.
Data Diary highlights two great charts by James Montier that highlight this relationship and the effect it had on the roll yield. Prior to this period the roll yield had a positive effect on commodities investing via futures, in recent history it has been a detriment. Data Diary goes on to argue that:
See in my day, commodities were in backwardation more often than not. What happened? It’s a result of the overpowering of physical markets by financial participants. And I’d argue that this investor dominated market structure increases the probability of extreme volatility in commodities prices.
This shouldn’t come as a great surprise. At the outset of the mainstream commodities investing boom Erb and Harvey had a piece up examining commodity returns and showed that the s0-called equity-like returns were a mirage. The returns from commodities investing came largely from those commodities in backwardization and those demonstrating momentum. In short, there was no free lunch.
Where does this leave investors facing the questions of asset allocation in a more volatile age? In short, commodities are not a one-way bet. A passive approach to commodities investment glosses over the complexities of actual commodity investment. The headwind of a broad variety of commodities in contango makes an index-like bet problematic at best.
All of this begs the question: does it make sense to pay for actively managed commodities strategies? Phil Davis at the FT examines this very question with some active managers. One interesting thing he notes is the use of equities to play long-term views on a commodity. This strategy can avoid the costs needed to maintain a futures-based position.
Investors were likely naive to think that substantially changing the demand structure for commodities futures would not affect their returns. Many an investor was burned by buying ETFs based on commodity futures not knowing the true pricing backdrop. In the future investors will need to approach their investments in commodities and every other asset class with the knowledge that greater volatility is, for the timing being, here to stay and a more thorough approach towards valuation and a margin of safety is warranted.