Asset Class: Commodities (Broad Basket Index)

Original Investment Thesis (2/2018): I believe commodities are cheap relative to stocks (and other financial assets). They are cheap on a variety of measures and have performed horribly over the past decade.  Hardly anyone owns them and no one talks about them.  Perfect!  I am a stock guy and would rather own stocks but they are highly valued so I’m allocating to commodities until the situation changes (then will rotate back to stocks).  In the event of inflation, commodities should do well (maybe better than stocks for a bit).  This is also a diversifying investment (for what that is worth).  I have owned Rogers International Commodity Index (RJI) in the past and actually like the methodology they use better but the expense ratio is higher so I switch out of it in April 2019.

Current Thoughts (9/22/2019): Long term holding. No real change here since investment.  I continue to believe commodities are cheap (especially compared to other financial assets).  I believe they will provide great protection if/when inflation rises (potentially while other asset classes get hit).  If we continue to deflate, they will continue to do poorly (but so will other asset classes).

Why Am I Investing In Commodities? Even Though I Don’t Want To!

April 2019


Why I Don’t Like Investing In Commodities?

  • Extremely Volatile – If you look at commodity prices (both short-term and long-term) you will see massive price swings (boom/bust characteristics).
  • Return Based Solely On Price Movement – There is generally no income with commodities (like you have with other more traditional asset classes).
  • Expensive Asset Class – It is pretty costly to invest in most commodity type assets (expense ratios, physical storage, derivative rolling, spreads, can be illiquid).
  • Macro Dependent – There are a ton of factors impacting particular commodity prices. I have no particular expertise in any of it (and definitely less than seasoned, often specialized, commodity investors).

So Why Am I Investing In Commodities?

  • Inflation Protection – Since commodities are real assets their prices will almost always generally keep up with (or outpace) inflation over time. So do stocks…and I’d rather own stocks.
  • Diversification – There is a theory that a portfolio should be made up of multiple asset classes in order to be properly diversified.  OK…I guess?!?
  • Event Risk Hedge – The world we live in is a messed up place (disasters, wars, politics, currencies, markets, etc.).  Real assets hold value to everyone regardless of anything else going on (and independent of all that).
  • Value Of ‘Real Asset’ versus ‘Financial Asset’ – There are ways to view different classes against each other to see if one has gotten ahead of another (or trailing behind). These are not fool-proof but I believe are helpful.
  • Trailing Returns Are Lagging History – Commodities have had a tough decade!

Deeper Dive: Diversification

I currently have about 25% of my investment portfolio invested in commodities.  I’ve owned $RJI for a while (which is a broad commodity ETN). I don’t have a full position right now.  I also own a full position of physical gold and physical silver (actually overweight silver right now).  I am making no change to those positions at this time. Right now I’m going to add a full position to a broad commodity ETF. This analysis is of $RJI versus alternatives available.  It has been a while since I reviewed them and I want to make sure $RJI is still the vehicle I want to use.

Deeper Dive: Event Risk Hedge

Oh…and I believe the world is a mess…did I mention that?!?  I’m not a negative person, I’m not a permabear, I’m not a gold bug…but I am a realist.  Like the Cub Scouts taught me growing up…Be Prepared (for anything).

I think the biggest risk we face today in our financial lives is the risk of some strange, unexpected financial collapse.  Everyone is in debt up to the hilt and we are in the final stretch of a worldwide global debt supercycle. No one knows when that will end but we are definitely in near-unprecedented times in how we are dealing with things (with lots of money being printed to keep things afloat in my opinion).  I think holding something that has more or less held its own for thousands of years with at least some part of my portfolio makes sense. This is where commodities/real assets come in. Why? Because they are real assets and cannot be made up and cannot be conjured out of thin air like so many financial assets can these days.

Why do I believe this is the largest risk our financial system faces?  Interest Rates Are At 5,000 Year Lows! I believe the world is awash in debt…all of it…the governments, corporations, the people–$250 trillion or so.  All this debt is being serviced with artificially low-interest rates (being systematically manipulated by every Central Bank on the planet all at once).  We are at the lowest interest rates in all of recorded time (since “loan docs” where stored in clay pots). We recently had the lowest 10-year treasury rate ever recorded July 2016 at 1.5%.  So, if the entire financial asset system is valued based on interest rates being at all-time lows doesn’t that make financial assets valued at all-time highs. How will we recreate 5,000-year lows to keep it going?  The entire system stinks and something isn’t right. I’ll gladly stay out of debt as one way to protect myself and own some non-financial assets (like commodities/gold/silver) as protection. Whether the value of the financial assets is destroyed via inflation or deflation the purchasing power of gold will hold much better than any fiat currency.  The western world believes in its financial assets to a fault almost. Bear in mind that financial assets have only been around for a few hundred years…while real assets (like gold) have been around for several thousand years and held their value.

Besides that small (?!?!) problem I could also mention:

  • natural disasters,
  • wars (trade wars, currency wars, and live/hot conflicts),
  • politics, regulation, and taxes,
  • currencies,
  • demographics,
  • market disruptions/financial collapses,
  • Etc.

I think real assets will hold up well if any of these things happen.  They ain’t making anymore…and they ain’t going away!

Deeper Dive: Value Of ‘Real Asset’ versus ‘Financial Asset’

There are ways to view different classes against each other to see if one has gotten ahead of another (or trailing behind).  These are not fool-proof but I believe are helpful in determining when ‘financial assets’ are ahead of/behind ‘real assets’.

  • S&P 500 to Commodities ratio says buy commodities.
  • S&P 500 (and Dow) to Gold (and Silver) ratio says buy gold/silver (commodities).

Deeper Dive: Trailing Returns Are Lagging History

Financial assets (stocks and real estate) have had a great decade and a very decent two decades!  Commodities have had an abysmal decade (following a rip-roaring decade prior)! Of course, past performance is no indicator of future results AND you shouldn’t try to time the markets by jumping from one asset class to another (in the short term).  That said, I’m putting money into long-term positions (and trying to allocate into assets/asset classes that represent good values. Commodities look like that right now. When I put that with everything I stated prior it makes even more sense.

Decision Made

I’ve decided I want a full commodities position.  What is the best asset(s) for me to do it with? What do we need to look at to decide?

  • Assets Under Management
    • The largest ETFs in the ‘Broad Commodity’ space is still relatively small in the overall ETF world.  All ‘Broad Commodity’ ETFs make up $7.4 billion. Conversely, the single largest EFT on earth $SPY has $261 billion in AUM.
    • These amounts are also very low compared to the overall annual output of many of the actual commodities.
      • Energy’s annual output is around $1.7 trillion.
      • Metals (Industrial and Precious) annual output is around $660 billion.
    • There are many very specialized sector commodity ETF that can be investing in as well as individual derivatives and physical assets that can be invested in.  These are not practical for investment in this asset class for me as an individual investor however so a broad commodity that provides one-stop-shop access to the entire commodity market in a ‘one-stop-shop’ method makes a lot of sense.
  • Expense Ratio
    • One of the first things I look at with any fund/ETF is the expense ratio.  For most index type investments, it is the most important thing to look at (with turnover being second…although less important with commodity ETFs).
    • Commodity ETFs have higher expense ratios than most other traditional index stock-based ETFs.  The largest ETFs all have greater than half a percent expense ratios. I would NEVER have money in an ETF with this kind of expense ratio normally, but there is little alternative in this asset class.  I currently own $RJI with a .75% expense ratio. I hate that by the way!
    • The higher expense ratios have to do with the size of the assets under management.  It probably has more to with the fact that there is less competition in these alternative types of asset investments (and people will charge what they can get away with).
    • I highlight a fairly new (and starting to be fairly sizable) entry into this space $BCI with a .25% expense ratio.
  • Legal Structure
    • The legal structure within the commodities universe of ETFs is pretty diverse (more so than within the traditional stock and bond ETF universe).
    • I currently own $RJI which is an Exchange Traded Note structure.  This type of structure is not really preferred in my opinion because it carries with it the risk that the issuing/holding institution could go away (like bankrupt) and along with it so goes my investment (as I hold a note back by them rather than the actual assets). I hate that by the way!
    • I highlight a fairly new (and starting to be fairly sizable) entry into this space $BCI with the preferred Open-End Fund structure.
  • Weighting Methodology
    • Commodity indexes are much different than most stock indexes in how they are constructed.  Commodity indexes generally weight the commodities they hold based on ‘market cap’ (which is similar to how stock indexes do things).  The way they determine the weighting varies wildly but is basically based on two factors:
      • Production – Weighting is set on the amount of the commodity produced.  This methodology generally overweights energy since oil and gas are the largest commodities in terms of production in the world.
      • Consumption – Weighting is set on the amount of the commodity actually consumed worldwide.  This methodology is, in my opinion, the better way to do the weighting. It will ensure that agriculture rises in importance against the other sectors.
    • I view this difference as extremely important and the biggest reason that I chose $RJI to begin with.  The methodology they run their index is critical to the way that I want to be exposed to the commodities asset class.

My Pick?

Sticking with $RJI – Elements Rogers International Commodity Index-Total Return ETN? NOPE!

I’m going to sell out of my $RJI position and replace it with $BCI – Aberdeen Standard Bloomberg All Commodity Strategy K-1 Free ETF.  I’ve researched (and liked and owned Aberdeen ETFs before). They seem to be great values and well run. I like this ETF more than $RJI based on a variety of factors that are important to me.

  • Assets Under Management – Not huge but sizeable enough within the space.  It is a fairly new ETF so assets should grow as well.
  • Expense Ratio – At .25% it is not bad at all and much better than the .75% that I’m currently paying.  Managing the ongoing expense of this investment is super important (well any investment really).
  • Legal Structure – Getting out of an investment that has an ETN structure and into an Open-End Fund structure is a very good thing in my opinion.  I want to own the investment, in commodities, for all the reasons I stated earlier and I don’t want any additional risks associated with the issuer.
  • Weighting/Methodology – I ultimately chose $RJI due to its methodology where it was based on consumption and not production.  I felt like this was very important. I’m losing a bit of that by switching to $BCI but the trade-offs make it worthwhile (and the difference is not huge).  So it is worth the tradeoff in my opinion. This is my biggest question mark, however.

Long-Term Plan?  I’d Rather Own Stocks!

I’ll likely hold a commodities position of some sort forever but right now I have about 40% of my portfolio outside of stocks (in commodities/short term bonds).  This is nowhere near where I’d like to be. I’ve been working on developing some tools that will help me monitor things and as things change I would like to change that and get back into near 100% stocks with my portfolio:

  • Inflation/Deflation – Neither of these appearing will help stocks in the short-term.  Stocks hedge inflation well in the long-term. If stocks get depressed due to inflation/deflation issues it will create buying opportunities that will allow me to reallocate back to stocks.
  • Interest Rates – I expect more QE (with lower rates and likely helicopter money this time).  I don’t expect rates to rise dramatically. Either way rates and Central Banks will dictate the way financial assets rise/fall as economy plays out.
  • Performance – If my commodities position has better performance than financial assets I’ll be able to rotate back out of it over time.
  • Ratios Between ‘Real Assets’ and ‘Financial Assets’ Change – This can happen by ‘real assets’ going up against ‘financial assets’…or losing less (which might actually be the case).  Either way as loved becomes unloved and vice versa the ratios will change and I’ll reallocate accordingly.
  • Find Stocks At Excellent Valuation – If I find stocks that are businesses I want to own that sell at values close to intrinsic value I’ll buy them…regardless of what everything else is doing.  These will provide good absolute returns regardless of all this relative ‘stuff’. I’m obviously not finding those at the moment.

I’m sharing my analysis here.  If you have thoughts on it I’d love to hear them hit me up on Twitter @joeydean72

Published by deanorolls

Well, if I told you that you wouldn't need to go to my would you?!?!

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