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Commodities
Old 08-19-2008, 11:51 AM   #1
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Commodities

Why are commodities good or not good to have as a part of someones long term asset allocation plan?

Some background: My problem is, my parents are constantly asking me financial questions these days. I do not work in the financial industry, it is just a hobby I have recently picked up because I believe it is important to know in order to FIRE as quickly as possible.

My parents are fairly near to retirement, so they struggle constantly with balancing risk vs. reward. Beyond just attempting to stay within a certain stock/bond allocation, they seem to be pretty unsure on what sort of allocation to use beyond that, and more importantly, have problems sticking with it. They get very scared when the market does badly and very confident when the market is doing well.

So at the beggining of the year they bought a natural resources mutual fund (oil/natural gas), in order to have commodities. Now they are asking me if they should sell it after it when from a fairly positive return to a small negative return in a short period. I ask them if commodities are part of their long term portfolio (as opposed to being just their high risk play money) and why they want commodities, and they just stare at me blankly...


I could really use some insight. Thanks all.
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Old 08-19-2008, 12:00 PM   #2
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A mutual fund like that is the best way to be in commodities. If you believe that the Earth's resources are finite, and are being used up at an accelerating pace due to China and others building up their economies, then you should keep some around as part of an overall AA...........
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Old 08-19-2008, 12:01 PM   #3
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Two reasons to have at least some exposure to commodities:
  1. Inflation hedge
  2. Low correlation to stocks
Having said that, having a total market index or ETF gives some exposure, since you'll own oil companies, mining/metals companies, paper companies, etc.
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Old 08-19-2008, 12:06 PM   #4
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#1 Doesnt always work. Right now commodities are taking a beating at the same time inflation is rising.

#2 has worked historically. When a retail investor couldnt buy commodities with an etf and few people dabbled in them. How they'll work now that all the FinanceDudes have told their customers that its a good idea to have 3/5/?% in their asset allocation is anyones guess.
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Old 08-19-2008, 12:15 PM   #5
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Commodity ETFs are taxed differently than other ETFs. A google search will turn up the details but the gains are not deferred. ETNs seem to be better for those with taxable accounts.

Another thing, there is a saying that goes something like this. Commodities take the stairs up but they take the elevator down. If that is something your parents would be uncomfortable with then a pure commodity fund should be avoided.
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Old 08-19-2008, 12:21 PM   #6
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Originally Posted by cute fuzzy bunny View Post
#1 Doesnt always work. Right now commodities are taking a beating at the same time inflation is rising.

#2 has worked historically. When a retail investor couldnt buy commodities with an etf and few people dabbled in them. How they'll work now that all the FinanceDudes have told their customers that its a good idea to have 3/5/?% in their asset allocation is anyones guess.
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Commodity ETFs are taxed differently than other ETFs. A google search will turn up the details but the gains are not deferred. ETNs seem to be better for those with taxable accounts.

Another thing, there is a saying that goes something like this. Commodities take the stairs up but they take the elevator down. If that is something your parents would be uncomfortable with then a pure commodity fund should be avoided.
Probably good reasons to just accept the commodity exposure you get with a total market index.
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Old 08-19-2008, 12:23 PM   #7
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Originally Posted by cute fuzzy bunny;700248#2
has worked historically. When a retail investor couldnt buy commodities with an etf and few people dabbled in them. How they'll work now that all the FinanceDudes have told their customers that its a good idea to have 3/5/?% in their asset allocation is anyones guess.
People should realize that all of this is con game. The academic researchers and others who "discovered commodities" play their role, the advisors and FPs are the usually unknowing cheer leaders, the mutual fund companies are the dealers, and the "investors" are the marks.

The tiniest bit of thought would argue that commodities are inert as to income, so the only way they can be profitable is from clever market timing- buy high, sell low-or unexploited market anomalies. The commodity investment boom happened to coincide with a period of so-called normal backwardation and also reasonable short term interest rates. So an all-long all the time contract rollover strategy backed by T-bills was a winner without any judgment. Those two factors are gone now, so from now on until they return commodities will be good to the clever, disastrous for the others. Whether an all long oil or gold strategy is clever or dumb remains to be seen. But it does seem too easy to work for long.

Ha
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Old 08-19-2008, 12:33 PM   #8
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Ding ding ding!

Check out the chart for a commonly recommended commodities fund thats widely held by a lot of the slice and dice early retirees...

By the way, one particular analysis concluded that based on the historical data, a portfolio of small cap value and pcrix in equal amounts would net you a 6% swr.

Just make sure to strap on your protective head gear before you get started...
Attached Images
File Type: jpg pcrix.JPG (44.0 KB, 15 views)
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Old 08-19-2008, 02:07 PM   #9
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I believe that is the fund in question, as you can see, it was doing well, my parents hopped on the bandwagon in January 08 and now it is a bit below where it was in January 08, after it began falling heavilly during the summer.

My parents portfolio is also a mess in terms of allocation, they have about 50/50 stock/bonds, but they don't really have access to any total market funds through their retirement accounts. It forces them to slice&dice a great deal, which causes them to see some of their funds tank, which causes them to want to panic sell.

Not exactly sure what to tell them though still, when they originally asked me about buying oil, gold or both back in January, I told them I didn't know much about commodities and so wasn't too confident about buying either of them, especially since they were doing "well". (I have had my own portfolio for a few years now, I have used a target retirement fund of mostly total market in order to provide me some diversification when I don't have a lot to invest and am very young).
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Old 08-19-2008, 07:04 PM   #10
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I'd say offhand that if your parents dont understand commodities, they shouldnt own a commodity fund. They got into the party late and its my opinion that theres more downside than up right now.

Had they gotten in a couple of years ago, they'd have a little less downside risk.
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Old 08-20-2008, 09:42 AM   #11
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About the inflation hedge, I feel there is more to this than is let on by CFB. Oil is still up over 60% in the last year, as inflation is ratcheting up. Commodities are very heavily dependent on the underlying asset (dollars) so as the dollar does well, commodities do poorly, and vice versa. There are many other factors which contribute to the prices as well, but this is one of the major reasons that commodities and inflation are linked more than other investments.
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Old 08-20-2008, 09:59 AM   #12
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Looks to me like oil is dropping like a rock and so is gold, while inflation is concurrently shooting up. Granted, they both popped up a lot over the last few years, but the CPI was pretty low then. In fact, I'd argue that its the rising oil prices that caused most of the inflation.

Seems maybe some consideration as to which is the cause and which is the effect is warranted.

Right now gold and oil are pretty high due to speculative pressures and the dollar is improving in strength. I'm guessing that all of that isnt going to be good for commodities.
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Old 08-20-2008, 10:04 AM   #13
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Looks to me like oil is dropping like a rock and so is gold, while inflation is concurrently shooting up. Granted, they both popped up a lot over the last few years, but the CPI was pretty low then. In fact, I'd argue that its the rising oil prices that caused most of the inflation.

Seems maybe some consideration as to which is the cause and which is the effect is warranted.

Right now gold and oil are pretty high due to speculative pressures and the dollar is improving in strength. I'm guessing that all of that isnt going to be good for commodities.
True, it is probably a chicken or egg kind of deal. I suspect, however, that the "inflation" in the abstract term (general rising of prices caused by many things) is what caused the very quick and short term jump in oil/gold/NG/wheat (decrease in dollar) and that it is just now being cycled through the economy. In other words, the inflation now is coming in from the causes from July 07 to March 08. The second that the Fed cuts rates doesn't increase prices immediately, it is generally understood to be a short-term stimulus with long term inflation effects. What does short and long term mean? Up to you to decide 8). I put it around 10-16 months.
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Old 08-20-2008, 10:17 AM   #14
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True, it is probably a chicken or egg kind of deal. I suspect, however, that the "inflation" in the abstract term (general rising of prices caused by many things) is what caused the very quick and short term jump in oil/gold/NG/wheat (decrease in dollar) and that it is just now being cycled through the economy. In other words, the inflation now is coming in from the causes from July 07 to March 08. The second that the Fed cuts rates doesn't increase prices immediately, it is generally understood to be a short-term stimulus with long term inflation effects. What does short and long term mean? Up to you to decide 8). I put it around 10-16 months.
Or, housing bubble bursts, faith in economy falters, speculation moves to oil and gold as they're traditionally good hedges against dollar weakness. This increases speculation in corn (ethanol) as well as rapidly rising prices in production simply because energy costs more.

Realization that the euro is in trouble too and contracting demand lead to less oil demand, leads to less ethanol demand, leads to softening prices everywhere.

Bottom line, I don't think most of us understand the relationship. Personally, I don't understand commodities and I stay away from things that baffle me (well, except for women)
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Old 08-20-2008, 10:28 AM   #15
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Eh, I kept it simple. Looked to me like a lot of the increases in costs came from higher transportation costs and people/companies having to lay out more for fuel and energy.

Oil went up, prices went up, providers complained about the higher fuel prices as a cause for the price increases. Now that oils coming down (and I think its got further to go) I'm betting you'll see prices coming back down in six months or so.

Marquette...lets just hope that nobody comes out with a woman ETF.

Wow theres a plethora of prospective jokes in that one.
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Old 08-20-2008, 10:41 AM   #16
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Eh, I kept it simple. Looked to me like a lot of the increases in costs came from higher transportation costs and people/companies having to lay out more for fuel and energy.

Oil went up, prices went up, providers complained about the higher fuel prices as a cause for the price increases. Now that oils coming down (and I think its got further to go) I'm betting you'll see prices coming back down in six months or so.

Marquette...lets just hope that nobody comes out with a woman ETF.

Wow theres a plethora of prospective jokes in that one.
Aren't pimps rather diversified? Investing in a pimp sounds kind of like a woman MF.
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Old 08-20-2008, 10:46 AM   #17
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Eh, I was thinking more along the lines of being happy when your fund goes down.
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Old 08-20-2008, 10:46 AM   #18
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Aren't pimps rather diversified? Investing in a pimp sounds kind of like a woman MF.
They don't call it investing and, even if it's a fair exchange at market rates, it's illegal around these parts.

edit: There's also significant fund manager risk
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Old 08-20-2008, 10:51 AM   #19
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edit: There's also significant fund manager risk
Heheheheh!

I think a dollop of commodities is a very good idea for a diversified potfolio over the long haul. Take a look at how much some commodities helped the retiree in the 1966-1982 period.

As for right now, well, I am not convinced the correction in oil is over. Hard to tell with the other commodities (natural gas is very cheap, relatively speaking).
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Old 08-21-2008, 10:21 AM   #20
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Why are commodities good or not good to have as a part of someones long term asset allocation plan?
I recently investigated commodities (more precisely Collateralised Commodity Futures) in depth, following all the links to various papers I found in Boglehead forums.

I started off skeptical, it seemed to me that it was an asset class with no intrinsic expected return.

Then I read a convincing paper that showed you could expect to make 4.3% "diversification" returns and 1% "roll returns". Diversification returns are the profits you make from the buying low and selling high that is implicit in regular rebalancing of a portfolio with highly volatile components. "Roll returns" are the returns from providing insurance.

Even better, this is the only asset class with negative correlation to everything else we might invest in, so it makes sense to have some even if the expected return is quite low.

Then I read another more recent paper that showed that average roll returns have been falling for 30 years. Also, in modern commodity markets, someone invested in a commodity tracker is long a basket of commodity futures, however in each component commodity market, depending on where the weight of money is, you are either reaping insurance premiums for insuring someone against price falls, or paying insurance premiums to someone who is insuring you against inflation. Both the sign and magnitude of each roll premium is unknown to the index invester. Also, the values change all the time. Therefore the aggregate of the roll returns is a very confused figure which may enhance or detract from the basic 4.3%, and can't be expected to do anything consistently in future. So the commodity exposure a typical investor goes for, a fund/ETN that tracks a commodity index, is a very confused investment.

So I ended up where I started: 0% commodities is the right exposure at all times. The expected return from a long only CCF index tracker is unknown, may well be negative, and isn't stable. (Shares by contrast are stable, once you smooth out economic and stock-market fluctuations, you can expect returns that grow with the economy.)

Even if you don't agree with that, note my further conclusion, that commodities defy normal investing logic, in that tracker funds are likely to be worse performers than actively managed ones (with similar charges) where the manager can go long or short depending on where there are insurance premiums to be reaped.

I did toy with the idea of putting a portion of my assets in an account where I could manage my own long-short exposure inexpensively. It then occurred to me that such a fund probably wouldn't have the negative correlation to other assets that made commodities interesting in the first place. It would probably just have zero correlation. That's nice, but not good enough considering the risks involved. Which include the fact that being a short-term trader in markets one knows little about is not generally considered sensible.

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So at the beggining of the year they bought a natural resources mutual fund (oil/natural gas), in order to have commodities.
If the fund invests in shares in oil and gas companies, then that's not the same thing as investing in commodities, and most of what I talk about above doesn't apply. I would say this kind of investment is not a good idea, you are just over-exposing yourself to a very narrow sector or the stock-market. Just buying the stock-market as a whole is better. (I feel a bit hypocritical saying this, as I regard my REIT exposure as exposure to property rather than share asset class, even though I have to admit that the REIT prices seem to have a lot of short-term correlation with share prices generally.)
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