Commodities offer a diversification benefit in a long-term investment portfolio. Here we look at how to invest in commodities broadly with the best commodities ETFs.
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Introduction – Why Commodities ETFs?
Commodities – metals, energy, livestock, and agriculture – offer what's called an uncorrelation to the stock market, meaning the movement of one does not follow the other. Further, commodities sometimes move in the opposite direction (negative correlation) of stocks, providing a diversification benefit in one's investment portfolio, particularly during periods of market turmoil and unexpected inflation. This property makes Commodities more attractive to retirees and those with a low risk tolerance aiming to reduce portfolio volatility and risk. This is the whole idea behind holding commodities in the All Weather Portfolio.
The most popular singular commodity most people know of is gold. Here we're interested in diversifying broadly within commodities, which ETFs allow us to do. Historically, investing in commodities required experience, time, and effort in using futures contracts. Nowadays, we can simply buy shares of an ETF (Exchange Traded Fund) just like shares of a stock. This also allows us to avoid betting on any single commodity.
The 3 Best Commodities ETFs
Below are a few of the best commodities ETFs to do exactly what I described above.
PDBC – Invesco Optimum Yield Diversified Commodity Strategy No K-1 ETF
The most popular ETF to invest in commodities is the Invesco Optimum Yield Diversified Commodity Strategy No K-1 ETF. As the name suggests, this fund has the convenient bonus of not producing the dreaded K-1 form at tax time (K-1's are a headache), unlike most commodities funds.
PDBC has over $6B in assets and an expense ratio of 0.59%. This fund gets you exposure to 14 commodity markets including oil, gasoline, corn, gold, sugar, natural gas, soybeans, and zinc, by seeking to mimic the index of its older brother DBC, the DBIQ Optimum Yield Diversified Commodity Index.
COMT – iShares GSCI Commodity Dynamic Roll Strategy ETF
COMT is a comparable ETF to PDBC but is cheaper and less popular. COMT has about $2.7 billion in assets. It seeks to track the S&P GSCI Dynamic Roll Index, again providing exposure to 14 commodities. Also like PDBC, COMT does not issue a K-1 because it uses a wholly owned Cayman subsidiary to buy commodity derivatives.
COMT has an expense ratio of 0.48%.
BCI – Aberdeen Standard Bloomberg All Commodity Strategy K-1 Free ETF
BCI is an actively managed commodities fund from Aberdeen with about $700 million in assets. It's not really truly active though. The fund still has an underlying index but then tries to boost returns with its collateral. This index is the Bloomberg Commodity Index, which includes up to 27 commodity futures contracts.
Like COMT, BCI uses a Cayman subsidiary to buy its derivatives and thus avoids issuing a K-1. BCI is newer than the ETFs above, having launched in early 2017, but is much cheaper with an expense ratio of 0.25%.
But Should You Invest in Commodities? Probably Not.
So now I'm going to contradict most of what I said in the introduction above.
Again, commodities are physical assets like gold, oil, copper, livestock, coffee, agriculture, etc. Their value depends on their usage in production, and is directly related to supply and demand. Any position in commodities is therefore a speculative bet on the short-term future, rather than long-term growth associated with stocks, bonds, real estate, etc. As such, investors have historically turned to commodities as a hedge against uncertainty, but they don't even do a great job of that.
Unfortunately, commodities themselves are unpredictable by their very nature. Crops go bad. The weather changes. Macroeconomic policies shift. Alternatives to things like copper are found. Ownership, storage, and transportation of commodities increase costs.
Stock ownership is a claim on a company’s future earnings. A bond is a contractual obligation between a lender and a borrower, with interest payments going from the latter to the former. Ownership of a commodity is not value-producing; it involves no earnings or cash flow and is simply a bet on production and/or consumption at that time. A ton of copper will still be a ton of copper 10 years from now, and it pays no dividends or interest.
Commodities are obviously useful to your everyday life, but not so much as an investment in securities markets. Cash flow drives returns. Think of owning a commodities fund as just paying for their storage somewhere. With technological advances, we would expect commodity prices to fall or stay flat over the long term.
If a particular commodity remains expensive, cheaper alternatives will be found. If wheat prices rise, farmers will just plant more wheat next season, so supply rises and the price falls back to where it was. This supply and demand cycle can sometimes take years to complete, but over the long term we would again expect commodity prices to remain flat. After fees (commodities funds are typically pretty pricey; the popular PDBC costs 59 basis points), commodities are likely losing to inflation. And indeed they have historically; commodities have had negative real returns over the last 100 years.
Essentially, even in inflationary environments, investors have historically been better off over the long term holding just about anything other than commodities. And we now have assets like REITs, TIPS, etc. as alternatives. Even a narrow gold fund should be a better choice than broad commodities. Commodities may offer a tiny diversification benefit to lower volatility and risk, but we still want our diversifiers to have positive future expected returns. Moreover, commodities tend to become much more correlated with stocks at precisely the time we want to rely on them – during stock crashes.
Andrew Tobias, in The Only Investment Guide You’ll Ever Need, maintains that “it is a fact that 90% of all people who play the commodities game get burned. I submit that you have now read all you ever need to read about commodities.”
If you do want to buy one of the commodities ETFs above, note that because commodities are so volatile, you only need a dash of them in the portfolio to exert their intended effect. Commodities should not comprise more than about 10-15% of the portfolio in my opinion.
What do you think of commodities? Let me know in the comments.
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Certainly a long-term buy-and-hold strategy for commodities has a poor/zero/negative expected return for the reasons you outlined, but what are your thoughts about this from the perspective of leveraged futures contracts, such as the strategy used by VCMDX? I believe some of the ETFs you mentioned may use similar methods.
Given the right buy/sell/short strategy derived from thoughtful research and algorithm design, it would seem that this may be something with positive expected returns. Do you think such a strategy would then still maintain the purported commodities benefit of unexpected inflation hedging?
I believe that given the scenario we are facing ( Russia x Ukraine ) and some other geopolitical attrition + the CPI rise as a derivation from COVID I believe that commodities funds can be a good short term investment alternative, of course not to hold longer however a good way of make some good money short-to-mir-term