With inflation falling fairly rapidly already at 3%, is it time to rethink commodities?
What is a Commodity?
Let’s begin by defining commodities. The basic goods and raw materials typically sold on specialist exchanges. We’re talking about oil, gold, wheat, pork bellies, and there’s a number of ways we can own these commodities; four fundamental ways to own commodities. First, we can just own the commodity, direct physical ownership. That’s a bit of a pain. Gold coins may be the easiest, but you’ve still got to buy them. They usually have a pretty big bid-ask spread when you buy a coin, and then you’ve got to store them somewhere safe. If you want to buy a barrel of oil and bet on the oil market, you’ve got to figure out where you’re going to put those 55 gallon drums.
Investing in Commodities
Most people don’t want to deal with transaction costs and storage, so they engage in what’s called futures contracts. Futures contracts are a very, very efficient way to get commodities exposure, but there’s a drag. I don’t want to call it a tax, but there’s a name for, it’s called backwardation and contango, and it causes the futures contracts over time to not be quite as valuable as the underlying commodities. And then we have commodity stocks, and by that I mean just companies that own commodities, that mine them, that pull them out of the ground, oil companies, gold companies. We already have significant exposure to those companies within our traditional investment indexes. So when we buy those separately, we’re increasing our commodity exposure. And finally, there are commodity ETFs and funds. And because of the affirmation problems with direct storage, they tend to be full of commodity stocks and financial futures.
Benefit of Investing in Commodities
So what’s the benefit of commodities? They’re great inflation hedges, especially in times of runaway inflation. And when we didn’t know where inflation was going, we thought it was very important to get it. In fact, for a couple of years, the returns were fantastic. They’re also a non-correlated asset class. In English, that means they reduce the risk of the overall portfolio because when stocks go up, they may come down, and vice versa.
Risks Involved with Investing in Commodities
There are also downside risks that come with commodities reasons to not always have them in a portfolio. First and foremost, transaction costs. Futures have their own drag. We talked about that a little bit, their geopolitical risks, storage costs we already discussed. And finally, most misunderstood is even though in nominal terms, commodities go up in value, up in cost. In real terms after correcting for inflation, they actually tend to drop as we get more efficient at mining and producing those items.
So what’s our strategy? The usefulness of commodities from an inflationary perspective is now behind us. So we’re trading out of our commodity positions. They’ve done their job. We’ve waited to capture the most recent healthy dividend, and now, as we trade out, we’re looking for tax loss harvesting opportunities, and just an efficient exit. Commodities, from our perspective, are not long-term holdings. They’re tactical holdings in periods of uncontrolled inflation.
We wish you the best of non-inflationary investment success.
Paul is the founder and CEO of Avion Wealth, LLC. He leads a team of wealth managers in building and executing financial plans for high net worth individuals and families. Contact Avion Wealth to speak with a financial advisor.