The less-than-sunny forecast for many commodities is actually a good motive for holding them in client portfolios, says a thought leader in the area.
Pessimistic pricing in the futures market gives investors an opportunity to profit if a surprise comes along that boosts commodity prices, (surprises that often come at the expense of stocks and bonds), according to Pimco’s Robert Greer, an executive vice president and real return product manager at the Newport Beach, Calif.-based investment firm. Greer pioneered the principles behind the first investable commodities index in a 1978 article he wrote for The Journal of Portfolio Management.

Surprises are one of five drivers of potential return for commodity investors, something that Greer recently discussed at the J.P. Morgan Center for Commodities at the University of Colorado Denver Business School.

Most economic shocks push commodity prices higher, Greer said. “You are more likely to see a surprise supply disruption than a surprise big harvest or a surprise flood of copper onto the market.” On the other hand, unexpectedly weak economic activity that dampens demand for raw materials hurts prices.
Rebalancing between commodity sectors is a second source of potential return from commodities. Historically, it has added as much as 85 to 350 basis points of yield annually, Greer said.

Investing in either the Dow Jones-UBS Commodity Index or the Credit Suisse Commodity Benchmark automatically gives clients this potential benefit because these indexes rebalance internally to their target commodity-sector weightings. The other investable commodities barometer, the S&P GSCI Index, does not rebalance as prices change.

Perhaps the most complex component of return is convenience yield, or the difference between the price of a futures contract and the cost to store and carry the physical commodity. Convenience yield is typically, although not exclusively, associated with backwardated futures markets––that is, markets where the futures price is less than the commodity’s current price. That’s generally a positive scenario for investors. At the end of last year, 15 of the Dow Jones-UBS index’s 22 commodities sectors were in backwardation when measured over a 12-month period, Greer noted.

(The opposite of backwardation is contango, when the futures price of a commodity is greater than the near-term price. This causes investors to lose money when they roll expiring contracts into more expensive futures contracts.)

A fourth return driver is the commodity-price-risk premium, which rewards the investor for taking on the risk that the commodity’s market price could change before the contract expires.

The final return component is the T-bill rate, which investors typically earn on the collateral they deposit when investing in futures.

Greer touted the traditional inflation protection and diversification benefits of commodities, but noted that stocks and commodities have been positively correlated since the financial crisis. Lately, though, that relationship has weakened and it could turn negative if historical cycles repeat, he said.

Greer claimed that in all his years of advocating long-only commodity investing, he has never recommended buying commodities because they’re going up. “I’ve always said to buy them because you don’t know what’s going to happen and a surprise has the potential to impact all the investments in your portfolio.”

The godfather of commodities, as Greer was recently hailed at a Chicago Mercantile Exchange event, readily acknowledges their uncertain nature. “Things can go badly for commodities,” he said, “but an understanding of the asset class may give your portfolio better expected returns in a world where you don’t know what to expect.”