SAFT ON WEALTH: The case against commodities grows

Wed Jul 24, 2013 9:20pm BST

(James Saft is a Reuters columnist but his opinions are his own.)

By James Saft

July 24 (Reuters) - Buying commodities in order to diversify your portfolio might not be that bright an idea after all.

A new study from the Bank for International Settlements disputes the idea that adding commodities to a portfolio can lower the volatility of returns. Considering that this has been the bedrock idea underlying the buying and selling of commodities as an asset class over the past 15 years or so, this is big news. ( www.bis.org/publ/work420.pdf )

Taken in combination with trends negative for commodities markets like the migration of manufacturing back to developed markets and 3-D printing, there may be fewer reasons for investors to consider the asset class.

The study, by Marco Lombardi of the BIS and Francesco Ravazzolo of Norges Bank, looked at correlations between returns in commodities and equities markets and found that, having been about zero for a decade, they have increased markedly from 2008 to now.

Rather than moving in different directions, commodities markets have been moving along with equities, creating more volatility for portfolios.

Lower volatility, or a return that does not jump around as much, is a key concept in investing, as it allows you to take on more risk and get a higher overall return since you have a lower chance of being caught short by a sudden move in markets.

Unfortunately, that simply doesn't seem to be true anymore for commodities and ironically it seems as if the huge rush of investors into the asset class in recent history is a big part of the reason why.

Returns in commodities markets in the past were driven more than they are now by market-specific issues. Think about a refinery fire or a drought. Now, however, since more of the market is owned by investors rather than driven by users and suppliers there is a higher chance of prices being driven by a pass-through from shocks to the real economy. As those shocks also drive equity prices, correlations rise.

The authors do make the case for commodities investment, but based on evidence they see that you can predict commodity prices using information from equity markets, thus allowing you to better time allocations in and out. That seems to me dangerously close to saying that if you can predict equity prices you can predict commodity prices. Frankly, if you can market time (hint: you can't) you ought not to be bothering with commodities or academic research at all.

The great thing about diversification is that it isn't predicated on knowing the future, only on making sensible decisions about risk. If that is gone, a major support for commodities investment is gone with it.

CASE GROWS AGAINST COMMODITIES

This is also happening at a time when some other long-running trends may be beginning to darken the long-term outlook for commodities prices.

A variety of trends may be bringing more manufacturing back to the U.S. from China and elsewhere, the so-called "onshoring" process. This is partly because the discovery of new energy resources in the U.S. is lowering costs there, and partly because wage differentials between the two countries, while still large, have narrowed enormously in recent years.

Production in the U.S. is simply less commodity-intensive, both due to lower travel and energy costs, but also because U.S. infrastructure is relatively better developed than that of China or Thailand or India, making for fewer huge-energy intensive development projects.

As well, as Morgan Stanley economist Manoj Pradhan has pointed out, higher labor costs act as an incentive to minimize commodity use, reinforcing the commodity-negative impact of onshoring.

The development of 3-D printing, a manufacturing process in which objects are literally sprayed into existence rather than mass-produced, could also be hugely negative for commodities prices. In part this is because 3-D printing isn't all about massive scale, the way the assembly line is, allowing you to locate small manufacturing sites close to clients.

Well known futurist and investor Esther Dyson makes some interesting points about the implications of this, arguing that it will hit transport and logistic companies hard, as there will simply be less moving of stuff around in a 3-D world. ( here )

Dyson also notes that the rise of 3-D printing will lower the inventories which companies are forced now to hold on hand. As U.S. goods inventories total about $1.7 trillion, about 10 percent of annual GDP, the transition from assembly lines to on-demand 3-D printing will at the very least be a one-off shock to commodities prices.

I am sure there are many specialist investors out there who make, and will continue to make, very good money investing in commodities.

Given the high costs of active management of commodities investments though, and the very compelling reasons to think these are markets heading for a shock, now might be a good time for most of us to narrow our focus.

(At the time of publication, Reuters columnist James Saft did not own any direct investments in securities mentioned in this article. He may be an owner indirectly as an investor in a fund. For previous columns by James Saft, click on ) (James Saft)