Saturday, March 29, 2008

Hot Commodities

Commodities are of course the hot new asset class, and as a born contrarian I'm bound to think it's all bunk. Naturally, it would be good to come to a slightly more reasoned conclusion, so I have lately done a lot of reading about how this asset class works.

There are essentially two ways to invest in commodities: physically, and through futures trading.

Physical commodity investing does not have a stellar history over the long-term, as the first chart clearly indicates (though your eye may come to a slightly different conclusion if you look at the second). Presumably this decline in real commodity prices is driven primarily by technology -- we get better at digging stuff out of the ground, and we get better at making use of the stuff we dig out of the ground. I'm not sure if this is simply the same thing as saying that GDP is getting "lighter".

At any rate, actually burying gold or oil in your backyard does not appear to be a winning strategy. The other option is trading commodities futures. This turns out to be a pretty complicated game with its own rules that have little overlap with equity or debt markets. Which is why I find myself agreeing with Barron's that we may be seeing a bubble in the commodities futures markets that has little to do with the real supply and demand situation for the underlying products. Naive commodities speculators and institutional investors who read a white paper and decide they need 5% of their assets in commodities can now immediately and easily invest in an ETF. I doubt if all these people put in the effort required to understand exactly what it is they are investing in (MBS and auction-rate securities anyone?).

This is not meant to imply that investing in commodities futures over the long-term is not a potentially viable strategy. In fact, from the academic research I've read it absolutely is. I simply think that even the best strategy will produce subpar results when implemented at the height of a bubble.

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