Over two years ago, I added a position in commodity futures to almost everyone’s portfolio using the PIMCO Commodity Real Return Strategy Fund Institutional shares (PCRIX). A small allocation (approximately 3%) is a great defensive play aimed at bolstering your portfolio if the stock and bond markets have a depressed period of performance. The performance the last few years has been strong (up approximately 20%). However, the Commodities market plunged beginning in May. Suddenly, investors began to focus on rising interest rates and slower economic growth. The hot money (hedge funds) headed for the exits, aggressively selling commodity futures contracts, commodity-related exchange-traded funds and natural-resources stocks. By the end of September, the Dow Jones-AIG Commodity index fell 13% from its May high.
Is the bull market in commodities over? No and in fact commodities soared over 5% in November 2006. The downturn appears to be merely a necessary correction in an extended cycle that could run into the next decade. China and other populous developing nations have an insatiable demand for oil and metals. As these countries urbanize and build a middle class they will need raw resources to build homes, roads, cars refrigerators and dish washers.
Commodity futures generate return in several ways. First, the futures contracts guarantee a set price at a future date, and commodity producers pay what can be thought of as an insurance premium for that certainty. In essence this can be thought of as compensation for providing insurance to commodity producers who want to hedge their exposure to fluctuations in commodity prices. This insurance is largely independent of changes in commodity prices, so even if prices decline commodity futures can generate a positive return.
Commodity futures generate return in several ways. First, the futures contracts guarantee a set price at a future date, and commodity producers pay what can be thought of as an insurance premium for that certainty. In essence this can be thought of as compensation for providing insurance to commodity producers who want to hedge their exposure to fluctuations in commodity prices. This insurance is largely independent of changes in commodity prices, so even if prices decline commodity futures can generate a positive return.
Second, the collateral that backs futures contracts is invested and earns a return. It only takes a small amount of the capital to buy the futures contracts. The rest is the collateral. In PIMCO a small percentage of the assets are used to purchase commodity swaps that are designed to replicate the performance of the Dow Jones-AIG Commodity Index (DJ-AIGCI). The remaining assets serve as collateral and are invested in portfolios of Treasury Inflation Protected Securities (TIPS). These treasuries will probably generate returns in the low to mid single digits. This return can be added to the other return components.
Third, individual commodities are uncorrelated to one another, and as a commodity futures index is rebalanced a return is generated over time from reversion to the mean. This happens as strong-performing, over weighted commodities are reduced and weak-performing, underweighted commodities are added. This benefit can only be captured if the index is owned over many years.
All of this is in addition to any returns that would come from price changes in commodities that are different than what the market was expecting—i.e., if actual commodity prices ended up being much higher than what investors were expecting, those future contracts would appreciate in price. That’s what makes commodity futures a good hedge against inflation.
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