Commodities (gold, oil) are a poor strategy for portfolio diversification

Interestingly, what’s written below doesn’t recommend never investing in commodities – but that one should do so for the right reasons (you have good intel on where the price is going, or you wish to invest in a specific commodity producer).

Financial Post – Another culprit in the big hurt: Commodities hardly a strategy for diversification

It was an idea inspired by Ivy League research. The research said that enhancing your portfolio with a splash of commodities — things such as gold, oil and pork bellies — could allow you to reap stock-like profits while providing a safe harbour during market downturns.

It sounded lovely in theory. But commodity investing flopped in practice. Despite a mild recovery, broad commodity indexes are still below their levels of 2008. Rather than being a counterbalance to equities, commodities have bounced up and down in tandem with Wall Street.

To understand how important the fine print is, go back to 2006, when two Yale professors published one of the most influential finance papers in years.

Gary Gorton and Geert Rouwenhorst examined 45 years of market history and concluded that investing in commodity futures, while using U.S. treasury bills as collateral, produced returns just as good as putting money into stocks. Even more enticing was their conclusion that commodities tended to do well when stocks did badly.

To institutional investors, this was catnip. Putting money into commodity futures –contracts for the delivery of commodities in months to come — looked like the perfect way to balance the risks in the stock market.

Within months of the paper’s publication, money managers were searching for easy ways to invest in commodity futures. Fund companies obliged them by creating specialized exchange-traded funds (ETFs).

The new ETFs got off to a roaring start as money poured into what appeared to be a sure bet. Then the stock market sank in mid-2008. This was when the Yale professors had predicted that commodities should shine.

Commodities did no such thing. They plunged in line with the stock market, then struggled to recover only part of their losses. So much for big gains and reducing risk. What went wrong? One theory blames the global recession. Another theory is that the flood of money into commodities changed the nature of the market.

Paul Justice, an ETF strategist with Morningstar, says commodity markets used to attract a different set of customers than financial markets. The people who bought and sold commodity futures were farmers, energy producers and merchants that actually used the commodities, not financial companies.

Justice believes that the tidal wave of cash pouring into commodity futures overwhelmed the physical production of commodities. Competition drove up the price of commodity futures, leading to a situation where the future prices of commodities are habitually bid much higher than the current or “spot” price.

If Justice is right, commodity investing will continue to disappoint until the fast money exits the market. But even if he’s wrong, the recent disappointments demonstrate some of the factors that trip up naive investors in the commodity markets.

For one thing, commodity ETFs are relatively expensive. Most charge 0.75% a year in fees, double what many stock market ETFs charge. Then there is the fundamental nature of commodities. They don’t pay dividends or interest, so commodity investors make — or lose –most of their money by trying to outguess the market about where the price of, say, copper or natural gas will jump next.

If you’re still tempted to put money into commodities, ask yourself why. A broad commodity index, such as the iPath Dow Jones-AIG Commodity Index Total Return ETN (DJP/NYSE) or the iShares S&P GSCI Commodity-Indexed Trust ETF (GSG/ NYSE), can diversify your portfolio, but the experience of the past couple of years suggests that the benefits are dubious.

A more powerful reason to invest is if you have a strong opinion about where the price of a specific commodity is going next. You can choose from among dozens of ETFs that allow you to bet on individual commodities ranging from platinum to livestock.

Som Seif, president of Claymore Investments Inc. of Toronto, says the ETFs fall into three classes: ones that invest in commodities through futures contracts, ones that actually hold the physical commodity, and ones that hold shares in commodity-producing companies.

Each class has its drawbacks. Futures-based ETFs face the contango issue. Physical ETFs incur storage costs. Share-based ETFs introduce another layer of uncertainty because you’re now betting on company management as well as the commodity itself. You should explore the specifics of any commodity ETF that you choose to invest in. The past two years have taught that the devil is in the details.

Among the people fiddling with the details is Rouwenhurst, one of the Yale professors behind the commodity-investing study. While he acknowledges that the past three years have not borne out his original thesis, he’s soon going to be launching an index that will actively invest in commodity futures, based on the level of inventories in each commodity.

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