A diversified commodity fund might suit your needs. But watch those fees—and the wacky tax treatment.
Budget deficits are going to be insane. Moody’s belatedly admits that the U.S. Treasury is a questionable debtor. God knows what new surprises are coming from Washington.
What about having a commodity as an inflation hedge?
Gold is hot, oil is not. You could own a bullion fund (up 79% over the past three years), or you might feel safer diversifying your risks with a commodity futures fund. Such a fund holds derivatives tied to the prices of a basket of physical assets—crude oil, natural gas, precious metals, base metals, grains, livestock.
This survey covers commodity funds, both those that own bars of precious metals and those that hold derivatives.
Debate rages about whether commodities have any legitimate role for a long-term investor. Allan Roth, a financial advisor well known to Forbes readers, says commodity futures are a zero-sum game and therefore pointless. “In the aggregate, not a penny has ever been made in the futures market before costs,” he opines in a recent essay.
AQR, a big money manager and also a profilee here, has an ax to grind; it sells a commodity futures fund. Its view: “The evidence supports commodities as a potentially attractive asset class in portfolios of stocks and bonds.”
We will return to the debate about the desirability of owning contracts on crude oil, pigs and whatnot. But first, on the assumption that you have already decided to allocate some assets to the category, here is the roster of Best Buys. They are not particularly cheap in comparison to stock funds, but they are, in expense ratios, at the low end of what’s available for hard assets. All but the one from Vanguard are exchange-traded.
Are broad-based commodity portfolios a good investment? They have their moments of glory. They did wonderfully well during the rising inflation of the 1970s. They zoomed during the first two years of the pandemic. In the past three years the diversified commodity funds have disappointed, utterly failing to keep up with inflation, although the narrow subcategory of precious metals has done well.
Allan Roth is correct that futures trading is a zero-sum game. If you are long December Pork Cutouts on the CME, someone else is short, and the combined profit and loss on the hogs is $0. But there are two reasons why investors who are on the long side of commodities could make money over time. One has to do with hoarding, the other with production risks.
Hoarding explains the price of gold. Some of this stuff is used in jewelry and electronics, but the marginal buyer is stockpiling it to preserve wealth. Over the past century the price of gold has raced at a 2.2% average annual rate above inflation. Stocks did a lot better, but it has to be conceded that gold has preserved wealth.
The other driver of commodity futures relates to production. Corn for September delivery is now trading at $4.37 a bushel. It could be that the best estimate of what its spot price will be in September is $4.47, and that a farmer is willing to sell now for less because his production cost is $3.50 and he wants to take no chance of losing money. The speculator on the long side of the future expects a dime of profit for taking on the price risk.
Oil’s price reflects both hoarding and hedging. Since it doesn’t spoil if left in the ground, it’s an asset to hoard. At the same time, producers need to cover their costs. If an offshore platform runs $1 billion, it might make sense for the company financing it to sell futures, even at a price below what’s expected. Buyers, of course, also hedge, going the other way. This is a complicated market.
How much juice do you get from commodities? Matthew Jiannino, a quantitative expert at Vanguard, says they have a tendency to move five to seven times as fast (in the opposite direction) as an average bond. That is, you could reasonably pair a $100,000 commodities position with a $500,000 bond portfolio. But he is quick to add that the relationship is not predictable. There are times when both bonds and commodities are sinking.
So, should you own a commodity fund? To answer, I can offer only some speculative thoughts. (A) Commodities present an interesting but unreliable hedge against inflation. (B) They will generate a real return over the next century that will be positive but not as good as the return on stocks. (C) The returns on actively managed commodity futures portfolios will collectively be, before expenses, no better than the return on a commodity index, and after expenses worse.
The funds on our Best Buy list are priced at 0.4% of assets annually or less. Most of them are managed passively. But even the vendors of index funds sometimes can’t resist adding a little oomph. Thus, we have the iShares Bloomberg Roll Select Commodity Strategy fund, which tracks an index that contains the commodity contracts with the most favorable rolls.
Rolling is the process of replacing an expiring contract with a later-dated one. Sometimes the new contract is priced lower than the old one, a phenomenon called backwardation. The reverse, typical for gold, is contango.
In its prospectus for the fund, BlackRock informs us: “The underlying Index seeks to employ a positive carry strategy that emphasizes commodities and futures contract months with the greatest degree of backwardation and lowest degree of contango, resulting in net gains through positive roll returns.”
A question to ask: If this fund is buying only the good contracts, who’s buying the bad ones? The fund, at any rate, is not a stellar performer.
If you do put money into commodities, pay attention to expense ratios. Go beyond the cheapest only to get a specialty you really want (like industrial metals) or to get more liquidity. Note: The table is sortable on any column.
One other admonition: Hold one of the diversified commodity funds on the table only in an IRA. They are all set up as K-1-free funds, which are deadly in a taxable account.
Reason for this: One tax law says that the usual kind of investment company can’t own commodity futures directly. So it holds them in an offshore holding company, often getting commodity exposure via derivatives sold by investment banks. Then another tax law comes into play. This one says that offshore holding companies are wicked and should be penalized.
Here’s how the punitive tax regime works: Gains on the derivatives are taxed as ordinary income, while losses can’t be passed through to the investor and can’t be carried forward by the fund. So you could be whipsawed, losing money one year, making it back to breakeven the next, yet have to pay income tax on an imaginary profit.
If you had put $100,000 into the Vanguard Commodity Strategy Fund three years ago and reinvested all dividends, you’d now have $91,640. If you made the mistake of holding it in a taxable account, you would have had to declare $14,730 of ordinary income along the way.
The Invesco DB Commodity Index Tracking Fund is organized differently, as a partnership (with a K-1 tax form). Losses from it can be carried forward, and profits are taxed as a mix of Treasury interest and long- and short-term capital gains.
The Invesco partnership doesn’t make the Best Buy list because it costs a nondeductible 0.87% annually. In Invesco’s defense, it should be noted that this fee covers the salaries of traders who juggle the futures contracts, taking care not to overlook an expiration and have a carload of live cattle delivered to their offices. In a K-1-free fund, these trading costs are incorporated in the derivatives purchased from banks. Vanguard’s latest financial filing says it was paying an annual 0.13% for help from banks, making the total cost of money management 0.29%.
The gold funds aren’t as bad as diversified K-1-free funds at tax time. When you sell, you pay capital gain tax at the “collectibles” rate (a federal maximum of 31.8%, including the investment income tax). There’s no whipsawing, there are no dividends to declare and there is the possibility that you will hold forever and get a step-up at death. Gold hoarding is comparatively cheap, as low as 0.1% annually.
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