Do Commodities Hedge Against Inflation?

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Do Commodities Hedge Against Inflation?

Post by Rick Ferri »

It is doubtful.

In a new paper, Commodities as Inflation Protection, Andrew Marks, George Crawford and Jim Kyung-Soo Liew dispel the popular belief that commodities provide a good hedge against inflation. They use spot prices for commodities because these prices have long histories.

From the Abstact:

Inflation degrades the function of the US dollar as a storehouse of value. The goods and services which constitute the cost of living become more expensive in dollar terms. Commodities, and gold in particular, are often recommended to hedge that risk. Our work casts that popular advice into doubt, showing that inflation hedging with commodities is difficult, risky, and ultimately unreliable.

You do NOT need commodities to achieve your investment objectives.

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Re: Do Commodities Hedge Against Inflation?

Post by staythecourse »

looks like an interesting paper and looking forward to reading it in depth. Thanks for posting.

Good luck.
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Re: Do Commodities Hedge Against Inflation?

Post by larryswedroe »

Thanks for posting and I'll read over weekend but without having read it here's a big problem for the paper

If there is not a hedge than we would see low correlation with inflation and CCF
But there is positive correlation and importantly the correlation rises as the term increases

So at montlhly 70-3/13 its 0.17, quarterly its .37 and about same annually, but semiannually it rises to 0.41 and at four years it's almost .7

That could not be if it was not a hedge

The high volatility makes the correlation low in ST

This is straight forward

Also the data shows that CCF performs best in RISING inflation

Note CCF hedges UNEXPECTED not expected inflation.

Also note if this was true you would not see the negative correlation with bonds we see. Hard to square with the data, But I'll read with interest

Larry
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Re: Do Commodities Hedge Against Inflation?

Post by gerrym51 »

My question is what inflation.
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Re: Do Commodities Hedge Against Inflation?

Post by rmelvey »

At first glance this paper caused alarm bells to go off in my head. Notice how they are looking at commodities in isolation, not in the context of a portfolio that holds stocks, bonds, and bills. Sophisticated investors only care about what an investment contributes to an already diversified portfolio of mainstream asset classes.

I think a well done paper would have looked at rolling real portfolio returns. Everything I have seen indicates that adding commodities to a stock/bond/bill portfolio provides more consistent rolling real returns. Isn't that what investors care about?
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Re: Do Commodities Hedge Against Inflation?

Post by Jebediah »

rmelvey wrote:Everything I have seen indicates that adding commodities to a stock/bond/bill portfolio provides more consistent rolling real returns. Isn't that what investors care about?
This is true. From Le Simba, 1972-2102:

50/50... TSM/5YR
CAGR (real) -> 4.79
Sharpe -> 0.45


40/10/50... TSM/Commodity/5YR
CAGR (real) -> 4.96
Sharpe -> 0.53

Larry's recent blog post has more in depth numbers
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Re: Do Commodities Hedge Against Inflation?

Post by rmelvey »

Jebediah wrote:
rmelvey wrote:Everything I have seen indicates that adding commodities to a stock/bond/bill portfolio provides more consistent rolling real returns. Isn't that what investors care about?
This is true. From Le Simba, 1972-2102:

50/50... TSM/5YR
CAGR (real) -> 4.79
Sharpe -> 0.45


40/10/50... TSM/Commodity/5YR
CAGR (real) -> 4.96
Sharpe -> 0.53

Larry's recent blog post has more in depth numbers
It is even more pronounced if you adjust the numbers for inflation that you are using to calculate the standard deviation for the return/risk metrics.
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Re: Do Commodities Hedge Against Inflation?

Post by Browser »

Larry - skimming the paper I don't see anything that contradicts your statements about commodities.

1) not all individual commodities provide equally good inflation protection, but a basket of commodities does better.
2) commodities tend to provide better inflation protection over the long term than the short term
3) commodities do seem to provide better inflation protection for sharp or unexpected increases in inflation
4) commodity returns have very low correlations to stock and bond returns, thus providing a diversification benefit

The authors seem to conclude from historical data that stocks have provided better inflation protection with lower volatility than commodities over the long run. So, I guess it might be fair to say that you don't need commodities if the "long run" is your frame of reference. But that doesn't contradict the possible usefulness of commodities over the short run of unexpected inflation spikes, and usefulness as portfolio diversifiers because of low correlations to stock and bond returns.
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Re: Do Commodities Hedge Against Inflation?

Post by Rick Ferri »

The authors conclude that commodities provide diversification from stocks, but so does burying money in glass jars [my input]. They also conclude that you needed to be a good market timer to make a real return on commodities and that not all commodities have provided the same return. So, to win the game, simply pick the right commodities at the right time.

:oops:

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Re: Do Commodities Hedge Against Inflation?

Post by rmelvey »

Rick Ferri wrote:The authors conclude that commodities provide diversification from stocks, but so does burying money in glass jars [my input]. They also conclude that you needed to be a good market timer to make a real return on commodities and that not all commodities have provided the same return. So, to win the game, simply pick the right commodities at the right time.

:oops:

Rick Ferri
Rick,

You are forgetting that commodities combination of high volatility and low correlation boosts the geometric average return of the portfolio. Even if commodities have a long run geometric average real return of 0, the arithmetic average return can be much higher. When folding them into a diversified portfolio, you get to capture some of that arithmetic return from the commodities, contributing to overall portfolios geometric return.
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Re: Do Commodities Hedge Against Inflation?

Post by Rick Ferri »

That's the theory, anyway. I've never seen it actually happen in any portfolio in my 25 years managing money, but it sure sounds good and looks good on paper. People will surely pay a lot of money for the hope of a higher geometric return using backtested results.

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Re: Do Commodities Hedge Against Inflation?

Post by Barry Barnitz »

Hi:

Counterpoint provided in this 2011 paper, examining performance of inflation hedging portfolios including (1) publicly traded equity REITs as measured by the FTSE NAREIT All Equity REITs Index; (2) commodities as measured by the S&P Goldman Sachs Commodity Index (GSCI); (3) TIPS as measured by the Ibbotson Associates synthetic U.S. TIPS series, which is equal to the Barclays Capital U.S. Treasury TIPS Index from January 1997 onward, but is backfilled by Ibbotson prior to that; (4) US equities, as measured by the S&P 500 Index; and (5) gold as measured by the S&P GSCI Gold Index. All indexes measure total returns (i.e. income plus price appreciation).

Case, Bradford and Wachter, Susan M., Inflation and Real Estate Investments (November 29, 2011). U of Penn, Inst for Law & Econ Research Paper No. 11-33. Available at SSRN: http://ssrn.com/abstract=1966058 or http://dx.doi.org/10.2139/ssrn.1966058
Conclusions
According to the Gordon growth model, real estate can be considered a perfect hedge against inflation, under the strong assumption that future rent growth and discount rates move in line with expected and actual inflation rates. In this paper, the authors examine the historical performance of real estate as an inflation hedge in the period from 1978 to 2011, and compare it to other inflation-sensitive asset classes.

In the historical sample, looking at single asset classes first, commodities provide the best inflation protection, as per the measure of hedge effectiveness adopted here, with an overall success rate of 70% in high-inflation semesters (75% for energy commodities, and 61% for non-energy commodities). These results are only slightly sensitive to differences in the time horizon used to calculate returns, the demarcation line used to define high-inflation periods, and the choice of synthetic TIPS return series.

During low-inflation periods, however, commodities generated the lowest returns of any asset class considered. This large performance difference highlights the utility of constructing a balanced portfolio if performance in both high- and low-inflation regimes is the goal.

Historically, a Markowitz mean-variance optimization suggests that a blended portfolio, invested 49% in TIPS, 17% in equity REITs, 15% in commodities, 14% in stocks, and 6% in gold, achieves the maximum Sharpe ratio (0.54) across all semesters in our sample. The success ratio of this multi-asset-class portfolio is quite high 75%, but it also has considerable directional risk.

To mitigate the latter, historically, one could have invested slightly more in TIPS (54%) and commodities (22%), and slightly less in equity REITs (14%), stocks (6%), and gold (3%). Historically, this portfolio has provided not only a similar success rate (75%) in high-inflation semesters, but also a similar Sharpe ratio (0.52), with the advantage that the latter is identical in both high- and low-inflation periods.

Finally, investors seeking to maximize the success rate in high-inflation semesters, without regard to directional risk, would have chosen a more aggressive portfolio with 55% in commodities, 39% in REITs, 5% in TIPS, 1% in stocks, and no gold holdings. Historically, this portfolio has a success rate of 78% in high-inflation semesters, but considerable directional risk.

Different property types provide different levels of inflation protection, depending on the extent to which rents adjust to inflation. The property types expected to provide the strongest inflation protection are the ones characterized by short-duration leases, or by rents linked to revenues. Empirical data generally support these expectations, with self-storage, residential properties, and shopping centers having a success ratio from the mid-70% to the low-80% range in high-inflation semesters, higher than the industry average (71%), (see table 6).).

Although the authors have used publicly traded equity REIT returns in this paper, similar empirical analysis could in principle be conducted using returns on illiquid investments, i.e. properties themselves or private equity real estate investment funds. Unfortunately, the latter are typically estimated by appraisals, which are linked to inflation, thus making an analysis of their price sensitivity to inflation amount to tautology.

The empirical evidence examined in this paper suggests that a variety of assets have inflation-protecting characteristics. Real estate, considered a strong inflation hedge on conceptual grounds, has in fact performed as well as, or better than, other inflation sensitive assets, in the historical sample considered, and has not exposed investors to significant directional inflation risk. Indeed, based on both empirical results and theoretical arguments, real estate, accessed through publicly traded equity REITs, provides attractive return characteristics and deserves consideration in diversified
inflation-protected portfolios.
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Re: Do Commodities Hedge Against Inflation?

Post by Levett »

Respectfully: this retiree has not, does not, and will not go through the following thought process to keep my retirement income flowing--e.g.,

"You are forgetting that commodities combination of high volatility and low correlation boosts the geometric average return of the portfolio. Even if commodities have a long run geometric average real return of 0, the arithmetic average return can be much higher. When folding them into a diversified portfolio, you get to capture some of that arithmetic return from the commodities, contributing to overall portfolios geometric return."

In year 13 of retirement and still chugging along just fine.

I wish the same for everyone else. :thumbsup

Lev
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Re: Do Commodities Hedge Against Inflation?

Post by rmelvey »

Levett wrote:Respectfully: this retiree has not, does not, and will not go through the following thought process to keep my retirement income flowing--e.g.,

"You are forgetting that commodities combination of high volatility and low correlation boosts the geometric average return of the portfolio. Even if commodities have a long run geometric average real return of 0, the arithmetic average return can be much higher. When folding them into a diversified portfolio, you get to capture some of that arithmetic return from the commodities, contributing to overall portfolios geometric return."

In year 13 of retirement and still chugging along just fine.

I wish the same for everyone else. :thumbsup

Lev
I (barely) understand the idea of shunning new knowledge as a retail investor, but don't you think authors of an academic paper would have the competence to focus on what commodities do to a diversified portfolio? The closest they got was looking at the correlations.
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Re: Do Commodities Hedge Against Inflation?

Post by Levett »

Respectfully, rmelvey, I'm old school. Can't you tell?! :wink:

If I ain't broke, I don't fix it. :D

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Re: Do Commodities Hedge Against Inflation?

Post by nisiprius »

rmelvey, I'm just going to state what I believe but not try to defend it here.

I do not believe a zero return asset can ever improve a portfolio by virtue of low correlation or zero correlation.

The only way it can improve a portfolio is through negative correlation.

This applies both to the long-run expectation and to particular individual samples (periods of time). That is, if C has zero correlation with S in the long run, then in any actual specific period of time, due to sampling variations C will have positive correlations in some and negative correlations in others, but the negative correlations will just be because of luck and won't be persistent. In that case, C will help the portfolio during the periods of time of chance negative correlation and hurt it during the periods of chance positive correlation. But it is going to help it in the long term unless it has negative correlation in the long term: persistent, reliable, meaningful negative (not low, not zero, but negative) correlation. I don't think such asset pairs exist. There are some that do have essentially zero cross-correlations with each other (stocks and bonds; possibly, all four of the assets in the Permanent Portfolio). But not negative.
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Re: Do Commodities Hedge Against Inflation?

Post by NoRoboGuy »

Interesting no one is yet discussing the paper's findings about the success of energy as an inflation hedge. I would avoid commodity funds, but I will have to rethink whether it makes more sense to tilt towards a higher energy allocation within equities, like a sector fund, similar to what I am doing now with REITs.
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Re: Do Commodities Hedge Against Inflation?

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louis c wrote:Interesting no one is yet discussing the paper's findings about the success of energy as an inflation hedge. I would avoid commodity funds, but I will have to rethink whether it makes more sense to tilt towards a higher energy allocation within equities, like a sector fund, similar to what I am doing now with REITs.
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Re: Do Commodities Hedge Against Inflation?

Post by Rick Ferri »

Bonds provide income. Stocks and real estate provide real growth and income. Commodities provide no income and best keep up with inflation, but they might provide a portfolio benefit from occasional low correlation. This sets up two schools of thought that are often debated on this forum:

One school of thought is to invest only in asset classes that have a stand-alone real total return (stocks, real estate, bonds). It doesn't matter that commodities have occasional low correlation to traditional asset classes if the they provide no real return on its own.

A second school of thought is to forgo a portion of the real return provided by stocks, bonds and real estate and invest in commodities funds (that have much higher fees) because there is enough low correlation at times to "boosts the geometric average return of the portfolio."

I'm a cash flow investor. I opt for the first strategy.

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Re: Do Commodities Hedge Against Inflation?

Post by larryswedroe »

Browser
First, as I said have not read the paper, But I would agree with the conclusions as you outlined them. I've said the very same things.
Second, stocks are real return assets and over the VERY LONG TERM they may provide a hedge against inflation. In shorter term the correlations are negative. But that doesn't rule out the diversification benefits

Rick's statement again show that the he is looking at things in isolation. The burying money in jars statement shows this view and it clearly is the wrong way to look at things, leading to poor decisions. As I showed the addition of CCF to portfolio actually provided in terms of its impact a very high real return, because of the diversification benefit. And that has led to more efficient portfolios. If it was burying money in jars you would see reduced returns and less efficient portfolios. Rick says it's only theory and he hasn't seen it in 25 years, but I just showed in my blog post that even in last 20 years with low returns to CCF that he did see it. He just was blind to it, not wanting to see it because it was there. In fact the data uses indices which both DFA and PIMCO shows are easy to beat even after expenses because of the transparency of the indices allows active managers to exploit them. Thus the realized returns would likely have been even better than I showed.

Have a nice weekend everybody
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Re: Do Commodities Hedge Against Inflation?

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MindBogler wrote:
louis c wrote:Interesting no one is yet discussing the paper's findings about the success of energy as an inflation hedge. I would avoid commodity funds, but I will have to rethink whether it makes more sense to tilt towards a higher energy allocation within equities, like a sector fund, similar to what I am doing now with REITs.
...until fusion reactors and nano batteries come online and we all start driving electric cars and oil / gas exploration is relegated to making chemical precursors for medicine and plastics manufacturing.

Whats that saying again? Stay the course.
A broad-based energy sector fund would (hopefully) update the components as the composition of the sector changes. I am curious whether such a tilt would have an inflation-hedge benefit, and will have to see if this has been researched. It is staying the course to seek low cost funds that will increase my risk-adjusted returns over long periods as this article attempts to study for commodities as an asset class. Not a timing strategy - a composition strategy that takes into account long term inflation. Staying the course for me includes being open to new information.
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Re: Do Commodities Hedge Against Inflation?

Post by larryswedroe »

louis
The answer is that it depends on whether energy is the main source of inflation as it was in 70s or not.
Also will depend on the ERP in the stocks because what if you have rising energy prices but the government taxes away the profits as say "excess profits"--a risk of stocks.
or that governments, especially foreign ones, confiscate properties, another stock risk.
Another reason why I prefer a broad commodity index-more likely to mirror overall inflation than anyone commodity would
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Re: Do Commodities Hedge Against Inflation?

Post by Rick Ferri »

Larry Swedroe wrote:Rick says it's only theory and he hasn't seen it in 25 years, but I just showed in my blog post that even in last 20 years with low returns to CCF that he did see it. He just was blind to it, not wanting to see it because it was there. In fact the data uses indices which both DFA and PIMCO shows are easy to beat even after expenses because of the transparency of the indices allows active managers to exploit them. Thus the realized returns would likely have been even better than I showed.
Hypothetically, using simulated portfolio returns based on back-filled indexes and optimized strategies that have the benefit of perfect 20/20 hindsight, Larry is correct.

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Re: Do Commodities Hedge Against Inflation?

Post by NoRoboGuy »

larryswedroe wrote:louis
The answer is that it depends on whether energy is the main source of inflation as it was in 70s or not.
Also will depend on the ERP in the stocks because what if you have rising energy prices but the government taxes away the profits as say "excess profits"--a risk of stocks.
or that governments, especially foreign ones, confiscate properties, another stock risk.
Another reason why I prefer a broad commodity index-more likely to mirror overall inflation than anyone commodity would
Larry
Here is what the OP's referenced paper said:
Everything runs on energy. While no single commodity consistently outpaced inflation, one of our aggregates, energy, did. The energy aggregate is unique among the items in our study in that it earned positive real returns in every single period we measured, including 3.96% real returns from 1960-2012.

However, when looking at very long periods the possibility of technological change becomes significant – could a breakthrough in the price of solar energy, for example, eliminating the need for rare earths, lead to a change in demand for fossil fuels as dramatic as the transition from horses to automobiles for transportation?
I agree that comes at increased concentration risk, but wouldn't that be nominal if you are tilting? Since energy is already well represented in the broad index I would not tilt more than 10% within the equity allocation. Just considering for now - not changing based on what I have so far. To be clear, I am talking about a stock sector fund, not a commodities/futures fund.
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Re: Do Commodities Hedge Against Inflation?

Post by rmelvey »

Here is some "voodoo" for the commodity haters 8-)

100% Stocks CAGR: 9.68%
100% Gold CAGR: 8.9%
50% Gold / 50% Stocks CAGR: 10.74%

Diving in a little bit further, that combined portfolio CAGR is 1.44% higher than the weighted average of the components CAGRs. Whenever people try to trash gold or commodities as an asset class, they always leave out an expectation about a material rebalancing return. One that is very likely to persist.
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Re: Do Commodities Hedge Against Inflation?

Post by Rick Ferri »

rmelvey wrote:Here is some "voodoo" for the commodity haters 8-)

100% Stocks CAGR: 9.68%
100% Gold CAGR: 8.9%
50% Gold / 50% Stocks CAGR: 10.74%

Diving in a little bit further, that combined portfolio CAGR is 1.44% higher than the weighted average of the components CAGRs. Whenever people try to trash gold or commodities as an asset class, they always leave out an expectation about a material rebalancing return. One that is very likely to persist.
Yeah, well, you can data mine anything. Of course you left out time periods in your post. i would to if I were you. Here is the reality on gold:

Gold bugs swatted again.

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Re: Do Commodities Hedge Against Inflation?

Post by Browser »

rmelvey wrote:Here is some "voodoo" for the commodity haters 8-)

100% Stocks CAGR: 9.68%
100% Gold CAGR: 8.9%
50% Gold / 50% Stocks CAGR: 10.74%

Diving in a little bit further, that combined portfolio CAGR is 1.44% higher than the weighted average of the components CAGRs. Whenever people try to trash gold or commodities as an asset class, they always leave out an expectation about a material rebalancing return. One that is very likely to persist.
rmelvey - the problem I have with these data is that they are very period-specific. Your results are for the time period 1972-2012, I believe. However, it you look at the period 1975-2012 you find the following:

100% TSM: CAGR = 11.73%
100% Gold: CAGR = 5.40%
50/50: CAGR = 9.56%

I believe that the long-term return of gold and commodities should be equal to the rate of inflation -- at least there's no reason to expect it to be more than that. The long-term return of stocks is higher than the rate of inflation. If you combine the two equally-weighted, then the return will be lower than if you were 100% invested in stocks. However, you will have lower portfolio volatility because of the low correlation between gold/commodities and stocks. Both left-tail risk and the magnitude of right-tail gains are lower, which means that you are trading returns in order to reduce left-tail risk. There is no free lunch being paid for by Mr. Gold.
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Re: Do Commodities Hedge Against Inflation?

Post by rmelvey »

Browser wrote:
rmelvey wrote:Here is some "voodoo" for the commodity haters 8-)

100% Stocks CAGR: 9.68%
100% Gold CAGR: 8.9%
50% Gold / 50% Stocks CAGR: 10.74%

Diving in a little bit further, that combined portfolio CAGR is 1.44% higher than the weighted average of the components CAGRs. Whenever people try to trash gold or commodities as an asset class, they always leave out an expectation about a material rebalancing return. One that is very likely to persist.
rmelvey - the problem I have with these data is that they are very period-specific. Your results are for the time period 1972-2012, I believe. However, it you look at the period 1975-2012 you find the following:

100% TSM: CAGR = 11.73%
100% Gold: CAGR = 5.40%
50/50: CAGR = 9.56%

I believe that the long-term return of gold and commodities should be equal to the rate of inflation -- at least there's no reason to expect it to be more than that. The long-term return of stocks is higher than the rate of inflation. If you combine the two equally-weighted, then the return will be lower than if you were 100% invested in stocks. However, you will have lower portfolio volatility because of the low correlation between gold/commodities and stocks. Both left-tail risk and the magnitude of right-tail gains are lower, which means that you are trading returns in order to reduce left-tail risk. There is no free lunch being paid for by Mr. Gold.
Browser,

I think you are misinterpreting the point of my post. Looking at your numbers... an average of the two CAGRs is 8.565% but the portfolio returned 9.56%. So there was a rebalancing benefit of 1%. That's exactly what am I talking about.
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Re: Do Commodities Hedge Against Inflation?

Post by larryswedroe »

Rick
Hypothetically, using simulated portfolio returns based on back-filled indexes and optimized strategies that have the benefit of perfect 20/20 hindsight, Larry is correct.


You are correct (though not on the optimized strategy for GSCI which is production weighted) on the data going back to 1970, Which is why I showed also the last 20 years where you don't have that issue. And no hindsight needed.

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Re: Do Commodities Hedge Against Inflation?

Post by Browser »

rmelvey - yes I was aware that the 50/50 CAGR was higher than the weighted average returns. But your example was misleading because it implied that you can get a CAGR from a 50/50 mix that is higher than the CAGR from either stocks or gold individually. Yes, it's possible but that's an outlier that would only occur when the return from gold is unusally high, as it was from 1972-1974. Over most time periods, most of the time, the return from the combination is going to be lower than the return from stocks alone. The rebalancing benefit is delivered primarily in the form of lower portfolio volatility, which will improve CAGR. But a low return is still a low return.
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Re: Do Commodities Hedge Against Inflation?

Post by larryswedroe »

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That is correct, as I pointed out the issue of diversification return or rebalancing return is that the weighted average return of the components is less than the portfolio's return
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RyeWhiskey
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Re: Do Commodities Hedge Against Inflation?

Post by RyeWhiskey »

Just a cursory glance at the web reveals that commodity ETFs are quite expensive. The cheapest I can find is IAU (gold) at 0.25% and most basket commodity ETFs are 0.50% or more. If I were a short-term investor, a retiree perhaps, I'd think that I-bonds and/or a short-term TIPS fund would be a better way to go. I'm not, only 27 at the moment, so commodities aren't of interest to me.

Just my thoughts as a Boglehead thinking of cost as the fourth factor of investments. :beer
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Re: Do Commodities Hedge Against Inflation?

Post by WHL »

I'm going to lighten this thread up a little bit. Too many numbers and acronyms for my small head.

Regardless of PM's effect on my portfolio, they have a positive effect on me. Look at how damn sexy this thing is! She has lots of friends, too :) [effect? affect? someone correct me if I'm wrong!]

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Re: Do Commodities Hedge Against Inflation?

Post by dmcmahon »

Rick Ferri wrote:Bonds provide income. Stocks and real estate provide real growth and income. Commodities provide no income and best keep up with inflation, but they might provide a portfolio benefit from occasional low correlation.
Some might argue that bonds don't produce income either, at today's interst rates. Anther way to state this: when you include inflation, bonds appear to produce negative returns making an asset that simply tacks inflation look good by comparison. In short, the "no income" argument is a bit hard to swallow in the current environment.
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Re: Do Commodities Hedge Against Inflation?

Post by Rick Ferri »

Bonds have a positive real return in the long-term. It's true that in the short-term some bonds have had no real return and even negative returns. But then, even stocks and real estate also have had periods of negative real returns. They don't last.

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Re: Do Commodities Hedge Against Inflation?

Post by zotty »

nisiprius wrote: I do not believe a zero return asset can ever improve a portfolio by virtue of low correlation or zero correlation.
I stopped at this line. This is EXACTLY what i believe.

I also believe that there are some *skilled* community futures traders who can generate positive expectancy from momentum.

Make sure you pick a good manager. (sound familiar?)

The pretend world of spot prices and commodity indices doesn't exist. The real world risks are much higher and worth consideration.

1) 5% margin creates spectacular momentum and crashes.
2) wild west marketplace - MF Global goes bankrupt, this event freezes money locked in futures contracts. It's not like a CD or checking account. futures/options come with an expiration date. It becomes a total loss just because someone goes bankrupt. This isn't tin foil material, it's what happens when you can't trade before expiration.
3) turnover. How about those taxes?
4) time costs - just like debt. you are borrowing for the privilege of owning the asset class. It costs money.
5) contago, another expense for the privilege of owning the future.
6) front running by nimble (skilled) traders who get in front of larger futures traders and steal their/your money. Be sure to pick a good manager, someone you've never heard of. Hopefully it isn't a fraud. Otherwise, the little guys will eat your lunch.

No. It doesn't make sense. I'll pass on the theoretical, worked in the 70s, works if you find the right manager, and works if your brokers broker doesn't collapse, etc, et al.
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Re: Do Commodities Hedge Against Inflation?

Post by beardsworth »

WHL wrote:I'm going to lighten this thread up a little bit. Too many numbers and acronyms for my small head.

Regardless of PM's effect on my portfolio, they have a positive effect on me. Look at how damn sexy this thing is! She has lots of friends, too. :) [effect? affect? someone correct me if I'm wrong!]

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"Effect" was correct as you used it in both places. Obviously, the effect of shiny coins affects your entire affect concerning your portfolio, although you still might be able to effect a change in allocation. :)
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Re: Do Commodities Hedge Against Inflation?

Post by NoRoboGuy »

RyeWhiskey wrote:Just a cursory glance at the web reveals that commodity ETFs are quite expensive. The cheapest I can find is IAU (gold) at 0.25% and most basket commodity ETFs are 0.50% or more. If I were a short-term investor, a retiree perhaps, I'd think that I-bonds and/or a short-term TIPS fund would be a better way to go. I'm not, only 27 at the moment, so commodities aren't of interest to me.

Just my thoughts as a Boglehead thinking of cost as the fourth factor of investments. :beer
Exactly why I think the Vanguard Energy ETF (VDE) at 0.14% is a better proxy for commodities. I say proxy because what you are really doing is tilting a stock allocation towards commodity-based companies, not owning the commodity directly. While Larry is correct that energy is but one narrow component and you want commodity diversification, I compared the correlation of the energy index to the broad commodity index, and it just does not look that significant when looking at the long term performance over high inflation periods. It looks more and more to me like this fund would be the most efficient way to add a "commodity hedge" while still being in equities. While it may not be a pure benefit, you are getting at least some inflation-hedge benefit via the commodity aspect of the companies in the index. I reminds me of over-weighting gold mining stocks rather than owning the underlying gold either physically or via CCFs. Hmm...hey Vanguard, how about a combined gold miner and energy producers ETF at 0.14%? That might provide a substantial correlation benefit.
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Re: Do Commodities Hedge Against Inflation?

Post by larryswedroe »

Louis
Just keep in mind that you are taking the equity risks, which you don't have with CCF, and there are not only business risks but tax risks and geopolitical risks (like confiscation of assets, expropriation, etc).
That's why you get the ERP.
So you could have period with high inflation and the stocks you don't help because the higher energy prices don't translate into higher earnings. That's a risk
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Re: Do Commodities Hedge Against Inflation?

Post by rmelvey »

Jumping off of Larry's point, the best regression I have personally been able to run for annual gold price changes is using annual changes in the spot price of oil... R^2 in the mid 30s. Those gold miners are not going to like higher energy prices. Rising cost of production is bad for the producers, but good for the holder of the raw commodity. IMO that is what CCF/gold exposure is all about. Hedging against supply shock. There is no reason to expect equities to hedge against that kind of inflation. They are only good at hedging a demand driven credit boom inflation.
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Re: Do Commodities Hedge Against Inflation?

Post by LadyGeek »

Acronym definition: CCF = Collateralized Commodity Futures

I'm not familiar with a CCF, so I found a helpful post: Subject: Collateralized Commodity Futures ? - Larry's Article (from January 2008)
schwarm wrote:these funds go long on commodities futures, essentially providing insurance to commodities producers. The futures collateral is invested in gov't backed bonds. The funds generate returns from 1) bond return 2) "insurance premium" and 3) internal re-balancing. These funds are highly volatile, but seem to be negatively correlated to stock and bond returns, making them a good diversifier. I think because of 1) their esoteric nature 2) high volatility, 3) lack of long history of returns (indexes have been around, but not invest able funds) and 4) relatively high cost, their usefulness is somewhat disputed.
Update: Removed question, not needed.
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Re: Do Commodities Hedge Against Inflation?

Post by NoRoboGuy »

Larry and rmelvey, I agree with both of your points, but they do not really address the efficiency aspect, meaning benefit vs. cost. CCFs are expensive and bullion comes with a carrying cost. Why is CCF or bullion more efficient? Also is not supply shock only one type of unexpected inflation?

Edit: I do not think tilting to VDE is an industry bet. I say this because of the OP's paper and the higher correlation of energy performance during periods of unexpected inflation. As such, it is a long term strategy akin to tilting to small value. I would expect that the benefit from any tilting strategy to be modest, but as Rick has said, the game is played in small fractional benefits to the portfolio. I understand that the equity risks diminish the benefit. I do not agree they eliminate it.
Last edited by NoRoboGuy on Sat May 25, 2013 1:07 pm, edited 2 times in total.
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Re: Do Commodities Hedge Against Inflation?

Post by bmdaniel »

nisiprius wrote:rmelvey, I'm just going to state what I believe but not try to defend it here.

I do not believe a zero return asset can ever improve a portfolio by virtue of low correlation or zero correlation.

The only way it can improve a portfolio is through negative correlation.
Nisiprius -

Just saw this comment; obviously this is related to the point on rebalancing and kelly criterion from the other thread, but it is clear at least in the contrived "Shannon's Demon" example that holding a zero correlation, zero return investment can significantly improve risk-adjusted portfolio returns.

There's a separate question of why you would hold this in the form of zero return commodity fund relative to just cash unless you thought there was actually negative correlation.
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Re: Do Commodities Hedge Against Inflation?

Post by rmelvey »

bmdaniel wrote:
nisiprius wrote:rmelvey, I'm just going to state what I believe but not try to defend it here.

I do not believe a zero return asset can ever improve a portfolio by virtue of low correlation or zero correlation.

The only way it can improve a portfolio is through negative correlation.
Nisiprius -

Just saw this comment; obviously this is related to the point on rebalancing and kelly criterion from the other thread, but it is clear at least in the contrived "Shannon's Demon" example that holding a zero correlation, zero return investment can significantly improve risk-adjusted portfolio returns.

There's a separate question of why you would hold this in the form of zero return commodity fund relative to just cash unless you thought there was actually negative correlation.
Going off of this... when people say that gold or CCF has a long run real return of 0, they are citing average geometric returns. Even assuming a geometric average return of 0, because of the volatility of those instruments, they necessarily have an arithmetic average return greater than 0. You can capture part of that arithmetic return when combining it with other low correlation asset classes.

You can't look at risk or return in isolation. The latter gets way less attention on this forum because it is not terribly material with TBM/TSM but the diversification return is very real with more volatile asset classes.
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Re: Do Commodities Hedge Against Inflation?

Post by bmdaniel »

rmelvey wrote: Going off of this... when people say that gold or CCF has a long run real return of 0, they are citing average geometric returns. Even assuming a geometric average return of 0, because of the volatility of those instruments, they necessarily have an arithmetic average return greater than 0. You can capture part of that arithmetic return when combining it with other low correlation asset classes.

You can't look at risk or return in isolation. The latter gets way less attention on this forum because it is not terribly material with TBM/TSM but the diversification return is very real with more volatile asset classes.
Have you ever looked at whether a mixed portfolio of cash and CCF with ongoing re-balancing would have a positive geometric return?
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Re: Do Commodities Hedge Against Inflation?

Post by larryswedroe »

Got chance to read this morning. Here are some thoughts on the paper.

Very weird statement in the abstract of the paper, makes one wonder about the rest of the content
A basket of commodities to protect against inflation would be difficult to construct
This makes no sense whatsoever as there are several available baskets of commodities and certainly not difficult to construct an index type for any specific types one wanted to hedge if you wanted to do that, such as agricultural or with or without energy.

The paper then discusses that stocks have outperformed commodities. Now there's an insight (:-)) Stocks certainly should be expected to outperform, as they have risks that carry risk premiums demanded by investors. There are no real expected returns to either commodities or CCF. But that is irrelevant to the question of do they hedge inflation and irrelevant to the issue of should you hold them in the sense you also have to consider correlations and volatility, plus return on collateral, minus the costs. They note the SR's of stocks vs commodities, but that again is wrong way to look at it. It's what's the SR when you ADD CCF. Not in isolation.

The issue of do they hedge inflation is easily answered by looking at the correlations, which amazingly they did not do (unless I missed that) No matter what the horizon you find positive correlation and as you would want to see the longer the period, the higher the correlation--at 4 years it's over 70 percent. Given that it's hard to make the case that they don't provide some hedge against inflation as that means when inflation is above average commodities have a very strong tendency to produce above average returns, and vice versa.

They also look at the individual commodities--again to me irrelevant how they performed. You want to look at a basket --it's like looking at individual stocks, most of which underperform the market, but that's irrelevant to the returns of a market portfolio.

They do note that commodities tend to perform best when inflation is high--just when you need them to protect the bond side of the portfolio (and stocks also negatively correlated with inflation). That's the insurance component. I have noted this in my books/papers showing this very fact, and showing that they tend to perform worse in falling inflation (when not needed)---That of course is why commodities have been strongly negatively correlated with bonds, and will always likely to do so. The other reason is that commodities tend to see rising (falling) prices in strong (Weak) economies just when bonds then see rising (falling)real rates. Again why commodities and bonds have negative correlation.

They do note the low correlations of commodities to stocks, but show there are times when there are high correlations--exactly what theory would state (see above paragraph). So commodities hedge SOME of the risks of stocks (not all, supply but not demand shocks) but hedge bonds much better.All this I have written about and discussed many times.

They also note that you need a long horizon--really? That is the case with any volatile asset. And commodities are highly volatile. For logical reasons.

Bottom line here is there is nothing I see in this paper that provided any new insights or anything that provides convincing evidence that one should not consider commodities

Hope that is helpful
Best wishes
Larry
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Re: Do Commodities Hedge Against Inflation?

Post by Browser »

Larry - I thought that when they said it would be difficult to construct a basket of commodities they were referring to actual spot prices of physical commodities -- not to baskets of commodity futures. The "baskets" you refer to use commodity futures. Their paper addresses spot commodity prices, not futures prices. It would, of course, be impossible for individual investors to own actual commodities.
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Re: Do Commodities Hedge Against Inflation?

Post by larryswedroe »

Broswer
I agree, but no one would want to own a basket of SPOT commodities anyway-that makes no sense.
While you might want to compare returns of CCF to what happened to spot commodity prices there is no reason to look at hedging using spot prices
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Re: Do Commodities Hedge Against Inflation?

Post by zotty »

Maybe I'm just completely anti-intellectual about this, but i can't overcome the instinct that tells me that the correlations are simply happenstance. That, in the end, it is a gamble on a sparse data set. so much weight is put into backtesting. How can we be sure there is statistical significance? How can we be sure the model is appropriate?

I am probably very biased by my employment, but i think the hundredth place correlations cited on bogleheads are a bit foolish. Do we *really* know the statistical significance?

Given that, i find it hard to invest in a market that depends on anonymous counterparties to make good. In the end, the will fail, and the government may not be inclined to bail out speculators that cost consumers money. It's not the same thing as owning a business or a loan to a business or a government. It's a much riskier market.
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Re: Do Commodities Hedge Against Inflation?

Post by larryswedroe »

zotty
correlations MAY be just coincidence but that is not the case with CCF as I have explained
There are very simple and logical economic explanations for the negative correlation of CCF to bonds and also the low correlation to stocks.
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