LESS ANTMAN’S CASE FOR COMMODITY FUNDS
As many of you know, Less Antman is as smart as they come. If you want to get his newsletter, or otherwise avail yourself of his wisdom, just click ‘Ask Less’ at the upper left of this page – the link with the discreetly blinking asterisk. (‘Try me,‘ that asterisk seems to be saying – ‘Try me.‘)
Here is his latest newsletter (please ignore all the mutual admiration):
When I was first starting out as an advisor, one of my regular quips to new clients was to tell them I needed to know their astrological sign in order to determine what percentage of their portfolio should be put into pork belly futures. I figured that anyone who thought I was serious was not going to make a good client. A few years later, it turned out I WAS serious (about the futures, not the astrology). For an investor, especially a retiree, it is important to consider all reasonable ways to reduce the volatility of a portfolio without substantially reducing expected investment returns. I have come to the conclusion that commodity futures can play a valuable role in the portfolio of most of these people.
Historically, a very common recommendation for widows and orphans was to split their money equally between stocks and bonds. The idea was that they needed the growth that could only come from ownership (equity) investments, but also needed to protect themselves from massive declines, and could do so by placing some funds in interest-bearing (debt) investments that were less volatile, at the cost of somewhat lower returns. To see how that would have worked, consider an investor if they had begun such a strategy at the start of 1972, and continued it for 35 years until the end of 2006. Assume also that their stock investment was allocated equally over the Standard & Poors 500 stocks (a list of large US companies in all sectors of the economy), and that the remainder was kept in short-term US Treasury securities. They would have had an annualized rate of return of 11.4% over that time period, and $10,000 invested at the start of the period would have grown to $436,900 (ignoring expenses). More importantly, if they checked their portfolio annually, they never would have seen a cumulative loss of more than 11%, which is a pretty modest decline given the excellent growth in the portfolio. You can see why this was considered a good, reasonably safe approach for widows and orphans.
Instead, though, let’s say they had split their money between stocks and commodity futures (using the reasonably balanced Dow Jones AIG Commodity Index). Over those 35 years, their annualized return before expenses would have increased to 12.8%, and $10,000 at the start would have become $686,400, which would have provided them with over 50% more money than in the stock-bond allocation. Of course, most people understand that the returns of a portfolio including commodity futures ought to be larger than one using short-term Treasuries, because of the much greater risk of the former. But checking their portfolio annually, the worst cumulative loss was only 10.2%, slightly SMALLER than the worst loss for the stock/bond portfolio. Much more wealth with virtually identical risk.
(For those who have seen similar examples with slightly different results in other writings of mine, please notice that this example is using the equally-weighted S&P 500, while my other examples used the traditional, market-weighted S&P 500: I prefer the former for reasons I discuss in other writings of mine, one of which is that the downside risk using it is smaller than portfolios that use the latter. I’m also using short-term Treasuries in this example instead of Treasury bonds, for the same reason. This article is about improving safety.)
This is the magic that results from understanding Modern Portfolio Theory (http://simplyrich.editme.com/ModernPortfolioTheory). Combining different risky assets produces a portfolio with the returns of those assets but with much less volatility. It is especially useful when the worst years of each asset tend to be the best years of the other. And that is a relationship that has historically existed between stocks and commodity futures. Higher than expected inflation generally has hurt stocks and helped commodity futures, and lower than expected inflation generally has helped stocks and hurt commodity futures. Combining the two investments has, as a result, provided a much smoother ride than either of the investments separately.
Most people are frightened when they hear about commodity futures, as they have some vague memory of it being a really dangerous investment. The first chapter of my dear friend Andrew Tobias’ book THE ONLY INVESTMENT GUIDE YOU’LL EVER NEED has a story about the danger of commodity futures, along with a statement that the overwhelming majority of people who invest in them lose money. This hardly sounds safe or prudent, but the use of commodity futures described in that chapter is nothing like the use in the allocation I described above. The example in his book was [typical retail commodities speculation] – equivalent to a bond investor who purchased junk bonds on margin in the 1980s, or a stock investor who bought highly leveraged options on dot-com stocks in the late 1990s, or a real estate investor who acquired no-money-down raw land in the current decade. They weren’t hurt by the investment category, but by making undiversified and heavily leveraged bets in those areas.
(My first exposure to the diversification potential of commodity futures came from an article by Mark Kritzman that Andy included in his ‘Managing Your Money Better’ software newsletter in the early 1990s. But the absence of any appropriate investment vehicle at the time kept me from using them.)
Let me start with a brief example of how commodity futures work. Commodity futures are very straightforward. Assume a wheat farmer is trying to obtain protection against a price drop between now and the date of delivery of the harvested wheat to the marketplace. The farmer sells a wheat futures contract and the buyer purchases it, with the contract to be settled at a time near the expected harvest (I’ll pretend it is a year, although actual contracts are for shorter periods). Since the farmer is, in effect, obtaining insurance against a decline in the price of wheat, the futures contract will be at a price that is lower than the expected delivery price of the wheat (which, by the way, is not the same as the current price). Let’s say the current estimate is that wheat will sell for $7.00 in a year. The current futures (sounds like jumbo shrimp) price might be $6.70, and the difference is essentially the cost to the farmer of the insurance on their livelihood. This means that, assuming wheat actually is priced at $7.00 when the contract is settled, the buyer will make 30 cents (the farmer will lose the same, but remember that they also will sell the wheat for $7.00 around the same time to Wonder Bread or whomever, and will net $6.70). Of course, if the price of the wheat is only $6.80, the buyer will only make 10 cents, and if the price of wheat is only $6.50, the buyer will lose 20 cents on the contract (the farmer will net $6.70 no matter what the price, and that certainty was the very point of their entering into this contract in the first place). Of course, if unexpected inflation causes the wheat to be worth $7.50 at the time of contract settlement, the buyer makes much more than expected (80 cents).
Notice that the deck is stacked in favor of the buyer of the contract: the farmer is willing to make a contract at a lower price because it is insurance to him. Historically, buyers of futures contracts who didn’t use any leverage earned a rate of return similar to that of insurance company stocks, which makes sense when you consider that the buyer of a futures contract IS essentially acting as an insurance company, and should make a rate of return similar to that of others in the business. What is most important is that the circumstances that would result in major losses to the buyer (lower commodity prices) is beneficial to the bulk of businesses, so that combining stocks and commodity futures in a portfolio appears to be an excellent way to reduce risk without reducing expected returns. This is why 30% of my own investable assets are in commodity futures.
The best way for most people to invest in commodity futures is through a mutual fund that holds a wide variety of commodity futures contracts. Diversification is always important, and for an individual to be able to duplicate the portfolios of most commodity futures funds, they would need millions of dollars in collateral. I’ve estimated that it would take approximately $5 million for an individual to duplicate the portfolio of the PIMCO Commodity Real Return Fund, which is my current favorite open-end mutual fund of this type because (1) it uses Treasury Inflation-Protected Securities as collateral, earning extra returns above the more typical Treasury Bills, and (2) the Dow Jones AIG Commodity Index it duplicates is the most balanced of all indexes that are currently represented by funds, as of the date I’m writing this piece.
I want to also address some common confusion that arises when I recommend commodity futures as part of a diversified portfolio:
(1) Commodity futures are not the same as investments in commodities themselves (such as gold bullion, coins, or trusts). The return on a commodity will only represent the change in its price, less storage costs, and this is far lower than the expected return on futures contracts that are insuring the commodity producer.
(2) Commodity futures are not the same as investments in businesses that produce the commodities (such as oil companies). The latter are affected somewhat by the price of the commodity, but also by general business conditions (very often prices have risen because of major production interruptions that hurt the stock) and general stock market fluctuations.
(3) Commodity futures funds don’t end up with the commodities in actual form. Futures contracts are always settled by the payment of cash based on the difference between the price index for the commodity at the settlement date of the contract and the price index at which the contract is originally struck (my stepfather used to speculate on pork belly futures in the dangerous manner described in Andy’s book, losing lots of money just as Andy’s book said usually happened, and I occasionally had nightmares of my stepfather forgetting to close a futures contract in time and having tons of dead pigs dumped on our front lawn by the seller).
(4) The diversification benefit of commodity futures is mainly a long-term phenomenon, and it doesn’t generally help much over periods of days and weeks. Correlation is the extent to which two assets move up and down together. If they always do so, they have a correlation of +1.00. If they generally move up and down independently, they have a correlation of 0. If they always move in opposite directions, they have a negative correlation of -1.00. On a daily basis, the S&P 500 & Dow Jones AIG Indexes have had a correlation of around +0.50 with each other. On a monthly basis, the correlation has been extremely close to 0. Over triannual (3-year) periods it has been -0.40. In fact, with the longest reliable indexes on commodity futures going back to the 1950s, I cannot find a single 3-year time period in which both US stocks and commodity futures declined, and suspect it hasn’t happened since the early 1930s, when the Federal Reserve System orchestrated an insane massive deflation of the money supply that triggered the Great Depression and that the current FRS chairman, Ben Bernanke, is virtually certain not to repeat.
As for the percentage of a portfolio that belongs in commodity futures, that depends on several factors, not the least of which is the comfort of an investor with investments that everybody tells them are risky. Although my clients trust my judgment, I haven’t yet put 30% of the portfolio of anyone other than myself into commodity futures. Because the income on these funds is generally taxable each year (unlike stocks and stock index funds, which can generally postpone capital gains indefinitely), it is best used in tax-sheltered accounts, and many people only have tax-sheltered investments in 401(k) plans at work, which rarely offer commodity futures funds as choices (although that may change in the near future, given all the academic research in support of their usefulness). Also, for a younger investor minimizing volatility is not as important as it is for an older investor, and dollar cost averaging can make a portfolio consisting entirely of stocks to be reasonably safe without the extra diversification. Thus, I am more adamant about using commodity futures for my retiree clients (which has always struck people as odd, but makes perfect sense if you understand this article). It is still, in my view, a good idea for younger investors, but given my earlier comment about 401(k) plans not offering them, I don’t get terribly concerned when a client under the age of 50 isn’t using them yet.
If you understand the potential usefulness of commodity futures, you will find that even a small commitment to them can reduce the overall volatility of your personal investment portfolio. Personally, I think any allocation less than 10% means taking an unnecessary risk, and most of the academic studies (which you can find all over the Internet with a few well-chosen Google searches) agree with me. In practice, few advisors approach the 20% to 25% that I use in many client portfolios (at least those with large tax-sheltered accounts), but the reason given for not doing so is often that the clients would resist putting so much into a category that scares them, or that the advisor doesn’t want results that will vary considerably from the performance of the US stock market. Personally, I don’t mind varying my clients’ results from the US market when the latter is in a free fall, and prefer to rid myself of clients who complain about commodity futures when they appropriately drag down a portfolio during a general bull market.
But you’re not my client, are you? So even if this piece (and answers to questions on my message board) are not enough to convince you to add this to your portfolio in quantities comparable to those I use for clients and myself, remember that even a few percent in this category will be better for diversification than not using it all. At least think about it, okay?
AND WHILE I’M QUOTING SMART PEOPLE
This comes from investigative journalist (remember those?) Greg Palast, whose newsletter is also free:
American Nightmare: Gonzales “wrong and illegal and unethical”
by Greg Palast
Tuesday, August 28
“What I’ve experienced in the last six months is the ugly side of the American dream.”
Last month, David Iglesias and I were looking out at the Statue of Liberty and Ellis Island where his dad had entered the US from Panama decades ago. It was a hard moment for the military lawyer who, immediately after Attorney General Alberto Gonzales fired Iglesias as US Attorney for New Mexico, returned to active military duty as a Naval Reserve JAG.
Captain Iglesias, cool and circumspect, added something I didn’t expect:
“They misjudged my character, I mean they really thought I was just going to roll over and give them what they wanted and when I didn’t, that I’d go away quietly but I just couldn’t do that. You know US Attorneys and the Justice Department have a history of not taking into consideration partisan politics. That should not be a factor. And what they tried to do is just wrong and illegal and unethical.”
When a federal prosecutor says something is illegal, it’s not just small talk. And the illegality wasn’t small. It’s called, “obstruction of justice,” and it’s a felony crime.
Specifically, Attorney General Gonzales, Iglesias told me, wanted him to bring what the prosecutor called “bogus voter fraud” cases. In effect, US Attorney Iglesias was under pressure from the boss to charge citizens with crimes they didn’t commit. Saddam did that. Stalin did that. But Iglesias would NOT do that – even at the behest of the Attorney General. Today, Captain Iglesias, reached by phone, told me, “I’m not going to file any bogus prosecutions.”
But it wasn’t just Gonzales whose acts were “unethical, wrong and illegal.”
It was Gonzales’ boss.
Iglesias says, “The evidence shows right now, is that [Republican Senator Pete] Domenici complained directly to President Bush. And that Bush then called Alberto Gonzales, the Attorney General, and complained about my alleged lack of vigorous enforcement of voter fraud laws.”
In other words, it went to the top. The Decider had decided to punish a prosecutor who wouldn’t prosecute innocents.
All day long I’ve heard Democrats dance with glee that they now have the scalp of Alberto Gonzales. They nailed the puppet. But what about the puppeteer?
The question that remains is the same that Watergate prosecutors asked of Richard Nixon, “What did the President know and when did he know it?”
. . .
During the Watergate hearings, Nixon tried to obstruct the investigation into his obstruction of justice by offering up the heads of his Attorney General and other officials. Then, Congress refused to swallow the Nixon bait. The only resignation that counted was the one by the capo di capi of the criminal-political cabal: Nixon’s. The President’s.
But in this case, even the exit of the Decider-in-Chief would not be the end of it. Because this isn’t about finagling with the power of prosecutors, it’s about the 2008 election.
“This voter fraud thing is the bogey man,” says Iglesias.
In New Mexico, the 2004 announcement of Iglesias’ pending prosecution of voters (which he ultimately refused to do) put the chill on the turnout of Hispanic citizens already harassed by officialdom. The bogus “vote fraud” hysteria helped sell New Mexico’s legislature on the Republican plan to require citizenship IDs to vote – all to stop “fraudulent” voters that simply don’t exist.
The voter witch-hunt worked. “Wrong” or “insufficient” ID was used to knock out the civil rights of over a quarter million voters in 2004. In New Mexico, that was enough to swing the state George Bush by a mere 5,900 votes.
So what is most frightening is not the resignation of Alberto Gonzales, the Pinocchio of prosecutorial misconduct, but the resignation of Karl Rove. Because New Mexico 2004 was just the testing ground for the roll-out of the “ID” attack planned for 2008.
And Rove who three decades ago cut his political fangs as chief of the Nixon Youth, is ready to roll. To say Rove left his White House job under a cloud is nonsense. He just went into free-agent status, an electoral hitman ready to jump on the next GOP nominee’s black-ops squad. The fact that Rove’s venomous assistant, Tim Griffin, was set up to work for the campaign Fred Thompson, is a sign that the Lord Voldemort of vote suppression is preparing to practice his Dark Arts in ’08.
It was Rove who convinced Bush to fire upright prosecutors and replace them with Rove-bots ready to strike out at fraudulent (i.e. Democratic) voters.
Iglesias, however, remains the optimist. “I’m hopeful that I’ll get back to the American dream. And get out of the American nightmare.”
Dreams. Nightmares. I have a better idea for America: Wake up.
Greg Palast is the author of Armed Madhouse: From Baghdad to New Orleans – Sordid Secrets and Strange Tales of a White House Gone Wild.
Sign up for Palast’s investigative reports at www.GregPalast.com
Tomorrow: The Little Book that Beats the Market; and Red Plastic Cups
Quote of the Day
A veteran Massachusetts politician not so long ago was horrified at the conduct of a less savvy colleague who was indicted for bribery: 'Imagine taking money from a stranger.'~Wall Street Journal, 10/14/93
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