Chapter Five

Conventional Alternatives I: Commodities

To Make a Killing, Take Out a Contract

On the great hunt for alternative assets to stocks and bonds, our first stop must be commodities. Many of us were introduced to the wonders of commodities as they were explained to Eddie Murphy in the movie Trading Places: coffee . . . that you had for breakfast . . . bacon . . . which you might find in a bacon, lettuce, and tomato sandwich. For our purposes, we expand this list to include:

Agriculture

Livestock

Energy

Industrial Metals

Precious Metal

However, our friend Jim Rogers recommends, “If you cannot spell commodities, I wouldn’t suggest buying commodities.” Don’t use the above as a shopping list next time you pull your big rig up to Costco. We’re talking about buying commodities in something called the futures market.

As Jim Rogers recommends, “If you cannot spell commodities, I wouldn’t suggest buying commodities.”

What is the futures market? We’re glad you asked.

Back to the Futures Market

Today, the center of the commodities world is the CME Group in Chicago, but the futures market for commodities goes back to Japan in the late seventeenth and early eighteenth centuries. This would have made a great Kurosawa film—Wall Street, Japanese-style.

Cut to: Osaka, Japan. Time: the early 1700s. Farmers bring their rice to the Dojima Rice Exchange to sell. A farmer pulls up to a warehouse with a cart full of rice and has to negotiate a price on the spot. The problem was—and is—that rice is harvested only once per year, but people need to eat all year long, so everything was riding on that one big sale. What’s a farmer to do?

The rice farmers realized that they needed to find a way to insure against getting a bad price. Otherwise, one bad day could wipe them out (and here we mean, literally, wipe them out). As a result, a way of transacting business was developed that served both parties better. The buyers were willing to guarantee the farmers a price in advance. They would offer them less than the probable final market price, but much more than a possibly disastrous market price. The buyers, on the other side, would be protected from having to pay an exorbitant price if supplies were low. The contract they drew up specified that a set quantity and quality of rice would be delivered at a specified future date to a specified location for this prearranged price.

With all the salient features of the transaction nailed down, a funny thing happened. This futures contract itself became a marketable commodity. A futures market—a clearinghouse for all these contracts—arose. This was incredibly useful, because it let everyone know the standard price and meant that individuals on either side of the transaction wouldn’t get an unfair (nonstandard) deal. It was beautiful. It got rid of all of the idiosyncratic and counterparty risk of one-off transactions. Over time, this model was applied to all the commodities on our shopping list.

Today, most people trading futures have no intention of either delivering or taking delivery of the underlying commodity. Those stories about the guy who forgot to sell his contract and had a truckload of hogs delivered to his front yard in Scarsdale are apocryphal. However, you don’t grow rice. You don’t grow cattle. What does this have to do with you and your investments?

How Do Investors Use Futures Markets?

Before we can talk about how to use the futures markets, we need to take a look at the colorful gang of customers who hang out there, at the Chicago Mercantile Exchange—the CME—where everybody knows your name. One group of people are speculators: people who feel they have a better slant on how the price of a certain commodity will shake down than everyone else does. In the movie Trading Places, the Duke brothers are in this position. They have illegally obtained an advance copy of the Department of Agriculture’s orange juice report and use this information to front-run the market. In your case, you might have a gut feeling about what the price of oil is going to do over the next year, and you might be right. Just be aware that you are trading against Ph.D. energy analysts from Exxon Mobil and Arab sheiks, and it is possible that they know even more about the subject than you do.

Other people you will meet at the exchange are often in some related business and looking to use the futures market to hedge their price. One might be an artisanal coffee grower who grows some fancy type of coffee. There is no specific futures market for coffee like his, so instead he sells contracts for coffee of the standard grade that is the one actually traded. He has no intention of delivering, so he will buy back the contract and cancel it before it comes due. In this way he will “cross hedge” his price with a commodity whose price closely parallels his own. If the price of coffee rises in the meantime, he will pay more when he goes to buy the contract back, but he will also make more money when he sells his own stash. If the price of coffee has fallen, he will not make as much when he sells his private brew, but will make money when he buys the contract back for less than he paid for it. Once again, he has locked in a price, just indirectly. (Yale economist Robert Shiller reports that when he visited the floor of the exchange where coffee futures are traded, he had the nerve to ask for a cup of coffee. They didn’t have any.)

A third group at the CME would be people whose businesses depend in some way on the price of the commodity. The Orange Julius company might want to lock in the price of the major ingredient in their devilishly good drink. They don’t want summer to arrive and then find their expenses going through the roof because of a poor orange crop earlier that year. It’s not easy for them to suddenly raise prices. They can cope by using futures contracts to hedge the price of orange juice months ahead of time. That way, there are no surprises.

So What?

We know what you’re thinking. Thanks for the history lesson, but why should commodities be part of my alternative portfolio? To be blunt, commodities are not what economists call earning assets—that is, assets that by themselves make money. If you own a plot of land, you can rent it or farm it and produce income. If you own a business, you can make gizmos and sell them at a profit. But if you own a bar of zinc, all it does is sit there. You can look at it, it can look at you, but it doesn’t actually do anything to make money for you. The only way it makes money is if somebody wants to pay you more for it than you paid when you bought it.

We can grant that the prices of commodities should keep up with inflation. Because commodities are the basic inputs to everything else, their prices cannot be insulated from a general increase in prices. They are generic—a pound of sugar is the same all over town—so there is no explaining away the uniqueness of a price rise across commodities the way there might be with some manufactured product. If a car or a suit has a price increase, there can always be a special explanation. But prices of commodities are completely elastic and react instantly to market forces.

If all commodity prices did was rise and fall with inflation, owning commodities would be about as enticing as kissing your aunt (of course, that could be very exciting, depending on your aunt). Is there any other reason why commodities should be considered an asset class for investors? Especially if we also concede that few of us are likely to have insights into individual commodity prices that are superior to those of all committed market participants like farmers and miners and oil producers?

The general answer must be supply and demand. To rationalize purchasing commodities, we have to subscribe to the view that demand will keep the prices of commodities rising.

The most popular version of this view may be put thus: As global capitalism transforms much of the world from subsistence agriculture to a post-industrial society with a chicken in every pot and a Starbucks on every street corner, there will be a tremendous demand for commodities for the big build-out.

More briefly still, there is China.

All the new cities being built in Asia are not going to be built out of bamboo. This transformation, if it is going to happen at all, will require beaucoup de commodities.

Each commodity has its own supply and demand characteristics. Oil has a library all to itself. Some commodities may be scarcer, some more plentiful, some easier to ramp up production and some harder, and some more in demand right now than others. However, the historical trend towards mass global prosperity is likely to exert pressure on the demand side for some time to come, barring a calamity.

Within each commodity, there is something called the “roll” return. This comes from the fact that, in most cases, the future price of a commodity is higher than the price today (the price today is called the “spot” price). This is because of storage costs, insurance costs, and interest rate costs. Why should someone go to the trouble of storing frozen orange juice when he could more easily put his money in the bank and get interest on it? The buyers need to be compensated for their service. For example, frozen orange juice concentrate will be cheapest the day of delivery (when it is most plentiful) and then rise in price over time as these other costs are added, right up until the next delivery date when the cycle starts all over again.

Of course, other factors like good or bad weather will also affect the price along the way. The strategy of rolling our commodities positions over, buying when they are cheap and selling as they rise in value closer to expiration, has usually added to returns, although this strategy can also turn against us if prices fall.

Finally, if we own a bunch of different commodity futures contracts in equal amounts, there can be (and in fact has been) an added return from the discipline of selling high and buying low as we rebalance our portfolio over time. Individual commodity prices are volatile and have low correlations to each other, leaving plenty of room to generate a portfolio diversification premium by periodically selling the ones that have gone up and using the proceeds to shore up positions in the others that are lagging.

Do Commodities Add Value to a Portfolio?

If we believe that commodities have almost any real positive expected return, they are going to have a place in our portfolio. Why?

If you believe that commodities have almost any real positive expected return, they are going to have a place in your portfolio.

Commodities did brilliantly during the stagflation of the 1970s, when they beat inflation by about 10 percentage points a year. They have tended to shine when stocks were having bad years.

However, what is foremost on investors’ minds these days is the liquidity panic of 2008, when commodities let us down. Investors who expected a big diversification benefit from commodities found the earth crumbling beneath their feet during the massive global deleveraging. The recency of this lesson and the magnitude of its pain should not blind us to the potential long-term benefits of using commodities in a portfolio. The next crisis is unlikely to be just like the last one.

According to one published paper on the subject, from 1970 to 2004, during which time the prices of individual commodities were more or less flat, a composite commodity index would have returned about 4 to 6 percentage points above the return on T-bills. This kind of return is enough to justify a meaningful allocation to most portfolios.

While the exact composition of commodity returns remains a puzzle, a 2006 Ibbotson Associates (a division of Morningstar) article on commodity returns concludes, “We believe most of these return drivers are likely to persist in the future and contribute to an inherent return for commodities.” At the same time, we have to acknowledge that it is difficult to get a fix on their long-term expected risks, returns, or correlations to everything else.

How Do We Invest in It?

You may have a can of coffee in the kitchen, some gas in your car, and a nickel in your pocket—these are specific products made from commodities. But even if you have a garage mahal, it is not going to be practical for you to store bales of cotton and bushels of corn. You might be able to store gold bars, but that is not without danger, either.

Some people think the best way to own commodities is by buying commodity producers: mining companies, oil companies, agricultural companies, and so on. This is wrong. Commodity producers are a hybrid between a commodity and a stock, with much higher correlations to the stock market than to the underlying commodities. You already own stocks. Buying commodity producers surrenders much of the diversifying power that was the reason for owning commodities in the first place. It’s better to cut out the middleman.

Another bad idea is to open an account with a commodity trading advisor. You object: Hillary Clinton did and turned $1,000 into a tidy $99,540 in 10 months with no experience whatsoever. Well, we suppose you can, too—if your spouse is governor and no one is watching. Otherwise, stay away from these shark-infested waters. You will be playing on margin in a casino where the fees and commissions are steep. We will have more to say about futures accounts later, but for now there is a better way.

Fortunately, commodities have been neatly packaged into ordinary mutual funds and exchange-traded funds. These funds are passive vehicles that track the performance of some commodity benchmark index. They are “fully collateralized,” which means our exposure to the underlying commodities is not leveraged.

There are several good funds to consider:

One important issue is that it hands you a K-1 for tax reporting purposes. Most owners will simplify their tax lives by housing DBC inside an IRA or tax-qualified account. Even then, the K-1 income can be taxed if it generates more than $1,000 of “unrelated business taxable income,” which the fund will assiduously try to avoid.

There are many other commodity funds out there. The PIMCO Commodity Real Return Strategy (ticker: PCRAX, among several share classes) is also supposed to track the Dow Jones-UBS Commodity Index, and puts the collateral into a PIMCO actively managed bond portfolio. If you like the PIMCO approach and you don’t have an advisor, you can get it for less by buying the Harbor Commodity Real Return Fund (ticker: HACMX), which has the same manager. By now there are many commodity sub-index funds that track the performance of individual commodities, but we don’t recommend these unless you are some kind of expert, which, frankly, we doubt.

Later on we talk about how much to buy in the way of a commodity index fund. In the next chapter we want to turn you on to the next “real” asset class, real estate.

The Alternative Reality

While not everyone agrees, we think a small allocation to commodities is a good idea that should improve the risk/return profile of your portfolio. The presence of several good commodity index funds makes this asset class easy to access for all investors.