Don’t Have a Cow

Adam M. Grossman

SOMEONE ASKED ME this week if he should own pork bellies in his portfolio. While he was kidding, this does get at a real question: Should you own commodities like cattle futures, gold, oil, lumber, soybeans and more?

Those who favor investing in commodities typically cite two benefits. First, commodities are seen as a bulwark against inflation. This is obviously a timely concern. Second, because commodities don’t move in lockstep with stocks or bonds, they’re seen as an effective way to diversify. There isn’t, however, universal agreement on either of these points, so it’s worth consulting the data.

Among commodities, gold has a particularly strong reputation as an inflation hedge. This stems mainly from its performance during the 1970s, when U.S. inflation was stubbornly high, peaking at more than 12%. Throughout that decade, gold rallied. At the beginning of 1970, gold traded at just $35 an ounce. By 1979, it had topped $500, and in early 1980 it hit $750. In the minds of many investors, this cemented gold’s reputation.

Critics, though, point out that in the years that followed, gold languished—not just for years, but for decades. Throughout the 1980s and 1990s, gold mostly traded in a range between $300 and $400. It wasn’t until 2007 that gold finally got back above the $750 peak it had hit 27 years earlier, in 1980. That was an awfully long time for an investor to wait just to get back to even.

Further detracting from gold’s reputation is that it did little to help investors during the recent bout of inflation. At the beginning of 2021, gold stood at about $1,900 an ounce. Where is it today? At about $1,900. In other words, during the worst inflation flare-up in more than four decades, gold did nothing to protect investors’ portfolios.

What should you conclude from gold’s failure to live up to its reputation? One explanation is that the gold rally in the 1970s was just coincident with inflation but wasn’t really caused by it. Instead, two other factors may have been responsible for gold’s rise during that decade.

First, the U.S. dollar, which had for decades been pegged to the price of gold, was removed from the gold standard in 1971. Without this tangible backing, many feared the dollar would devalue, and thus they sought out gold. Another factor driving demand for gold in the 1970s was the lengthy recession. This weighed on stock prices, making gold relatively more attractive as an asset class.

Taken together, the persistent inflation, economic downturn and stock market stagnation of the 1970s created a sense of uncertainty for many investors. This prevailing downbeat sentiment was probably another driver of demand for gold throughout that period.

Why do investors turn to gold in times of uncertainty? This is where the discussion around gold tends to devolve. One research paper points to this logic: In Babylon, during the reign of Nebuchadnezzar, an ounce of gold could purchase 350 loaves of bread. Since an ounce of gold has very similar purchasing power today, the argument goes, gold should be viewed as a timeless store of value. Others are quick to counter, though, that this loaf-of-bread argument is closer to folklore than to reliable data. Should we really base investment decisions on the price of bread 2,500 years ago? By way of comparison, reliable data on U.S. stock prices goes back barely 100 years.

Because gold has such a uniquely long history, and is thus susceptible to these sorts of pseudo-quantitative arguments, it’s worth turning our attention to broader commodity market data. Researchers Claude Erb and Campbell Harvey are the authors of a well-known paper on commodities, “The Tactical and Strategic Value of Commodity Futures.” They examine the value of commodities through numerous lenses. Their conclusion on the value of commodities as an inflation hedge: The benefit is “inconsistent, if not tenuous.”

What about the diversification offered by commodities? Using correlation as a measure, commodities do appear to offer a benefit. Correlation is measured on a scale from -1 to 1, with 1 indicating that assets move in perfect lockstep and -1 meaning the assets move in opposite directions. On this scale, over the past 10 years, the correlation between the Bloomberg Commodity Index and the S&P 500 has averaged just 0.4, suggesting commodities may offer a powerful diversification benefit. Gold looks even more attractive. The correlation between gold and stocks has averaged 0.1, meaning there’s almost no correlation between them.

The fly in the ointment: According to data from AQR Capital, commodity prices swing wildly. Historically, global stocks have returned about 10% a year, with volatility of 13.5%. Commodities, on the other hand, have returned just 8.2% a year but with volatility of 17.5%. In short, commodities have delivered lower returns with higher volatility. This is why, despite their perceived benefits, I don’t see commodities as a good fit for individual investors’ portfolios.

For those still interested in commodities, AQR, as well as Erb and Harvey, the researchers referenced above, arrive at the same conclusion: Avoid index-based approaches to commodity investing and instead opt for active management. That’s because commodity indexes have an Achilles’ heel: They’re usually top-heavy.

In the Deutsche Bank Commodity Index, for example, nearly half the fund is allocated to oil and gas, diminishing its diversification benefit. The alternative, though, is impractical in a different way. Actively managed funds are typically more expensive and less tax-efficient than index funds, with no guarantee that they’ll outpace the index, so I don’t see active management as a good alternative.

If there are no good options for investing in commodities like oil, pork bellies and cattle futures, where does this leave investors? My view: I wouldn’t worry too much about owning commodities, for two reasons.

First, as the data show, it’s debatable whether commodities are even necessary. The data on inflation protection and diversification is murky. Second, to the extent that there is a benefit, broad-based stock market indexes like the S&P 500 already include a number of commodity producers—from oil giant Exxon Mobil to lithium producer FMC to gold miner Newmont Corp. Owning these stocks isn’t quite the same as owning a commodity fund. But given the options, I see it as close enough.

Adam M. Grossman is the founder of Mayport, a fixed-fee wealth management firm. Sign up for Adam’s Daily Ideas email, follow him on Twitter @AdamMGrossman and check out his earlier articles.

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