Clients’ desire to diversify may be growing stronger, but this is one area where they should beware
Broad equities exposure has become less of a sure bet compared to recent years; on the bond side, balancing high yields against duration and quality considerations is as challenging as ever, if not more so. In this setting, one may understand the urge to diversify portfolios beyond traditional assets — possibly into commodities.
But when it comes to client portfolios, such a move is likely too radical and dangerous. “Commodities don’t make sense as a long-term investment, and most clients should avoid them,” reported WealthManagement.com.
A major bone of contention is the return expectations for commodities. Reflecting the wild movements that characterize the asset class, the inflation-adjusted Economist commodity price index has posted nearly zero returns since 1871.
Some may argue that commodities provide a hedge against inflation, but the fact that they don’t pay dividends is another point against them. “I like alternative investments to provide diversification, but I like income while I wait,” said Tom Fredrickson, a New York-based financial advisor with the Garrett Planning Network, who prefers Treasury inflation-protected securities (TIPS). “When you own commodities, you don’t get paid to wait.”
While a buy-and-hold approach to commodity investing may not work, tactical buying and selling could. But success requires time, attention, and savvy that most investors simply don’t have. Many investing professionals also see a gloomy short-term outlook for commodities in general, especially given the slowdown in global economic growth.
There are certainly some bright spots at the moment. Palladium has gone on a tear as winds from regulation and supply constraints blow at its back. Gold has also seen a resurgence in popularity, with prices reaching a six-year high from investors seeking inflation protection. That may inspire some appetite for mutual funds or ETFs offering exposure to such commodities, but investing in such products isn’t so simple.
A look at the expense ratios for commodity funds might give investors pause. According to data from Morningstar, the average expense ratio for commodity-focused mutual funds or ETFs totals 0.93% annually — only slightly less than the 1.03% average for US equity funds, and above the 0.86% expense ratio for taxable US bond funds.
The dependence of such funds on futures contracts also potentially exposes them to the weirdness of contango. If commodity prices increase, futures prices may escalate far beyond the spot price. Should this coincide with a rollover in a fund’s contracts, it would be forced to pay dearly for its new contracts.
The situation is made worse by the current interest-rate environment. Traditionally, commodity futures funds have derived a piece of their performance from interest income earned on cash collateral for the futures contracts. With rates at historic lows, and given the prospects for additional rate cuts from central banks, that return stream has dried up.
The naked exposure of commodities to supply and demand is another concern. Unlike stocks and bonds, which can be appraised partly based on corporate earnings or information about the issuer, commodities are more vulnerable to trends like shifts toward renewable energy, regulations that restrict mining, or climate-related events.