Commodities NOT for diversification? Should be obvious!

A published academic study (by Daskalaki and Skiadopoulos in the Journal of Banking & Finance October 2011) that’s getting much attention is entitled: Should Investors Include Commodities in Their Portfolios After All? New Evidence.

The following is a quote from the CFA (Chartered Financial Analyst) Digest Summary of the article:

“The authors….after thorough statistical analysis, they conclude that investor utility is maximized in a traditional portfolio and risk-adjusted returns decline after the addition of commodities.”

The common misunderstanding about “diversification” is that it magically enhances rates of return at the same level of risk, or mitigates overall volatility or ‘risk’ with the same rate of return. Never mind that ‘risk’ is never fully defined correctly (that’s the subject of another book) in the first place.

What about commodities? Stocks and bonds have a theoretical basis for being included in an investment portfolio – there ARE reasons to expect a “rate-of-return.” Companies are expected to be profitable and grow (at least the ones you deliberately had pick as a portfolio manager), providing returns on investment to the shareholders or business owners. Bonds represent loans by government and businesses – borrowed money with a built-in return for the lender. On the other hand, there is no theoretical basis for commodities per se to provide any return, never mind “enhance” a portfolio’s return. One might argue that increasing demand with limited supply should cause prices of commodities to rise – but this is gambling, not applied theory. There has been exponential growth in the demand for computing power, but the price of computer technologies has declined steadily and rapidly for decades.

The best you can expect by including a volatile ‘asset class’ (and I use the term asset with some reluctance since a commodity is more like a currency than as asset) is to reduce overall volatility – and if if there’s no implied or expected corresponding rate-of-return then the final overall portfolio return MUST be reduced. A percentage of the portfolio is wasted on a non-earning asset class.

SO THE STUDY EXPRESSES THE OBVIOUS, SO WHY THE FUSS?

Forget that the marketing ingenuity of commodity EFT’s, hedge fund managers and commodity trading platforms has been very effective (backtesting is financial equivalent of smoke and mirrors), while there has always been a chronic shortage of rational thinking.

The reason to use commodities, foreign exchange or mess with asset mix is to enhance return by actively gambling. Unlike Las Vegas where the odds are notoriously stacked against you, markets create plenty of opportunities for ‘educated’ gambling – employing judgement or techniques to skew the odds in your favour even if just temporarily. Such opportunities are often arb’d out in short order as others hop on the band wagon and price adjustments diminish the potential for gains.

It is virtually impossible to “study” the contribution from educated gambling without examining each and every portfolio out there, isolating the bets and discovering if they were contrived or anomalous, consistently earned versus shortlived, or just a monumental waste of effort and money. Reminds me of the lady in line to buy a lottery ticket. When I asked if she knew the odds of winning were one in many millions, she corrected me: “No, the odds are 50/50!” Taken aback, I asked how she figured that out? She said: “Either I win or lose, which is 50/50.” Next logical step? If she did win once, she could launch a hedge fund – after all if you backtest having a winning ticket every time, the returns for this ‘system’ are astronomical.

Hats off though to Daskalaki and Skiadopoulos for giving it a try!

Primer on Diversification:

The following is an excerpt from my book.

Let’s consider a few different approaches to diversification:

Case 1

Imagine you are equally weighted with half of your money in stocks and half in bonds when the stock market crashes. Suddenly, the stocks are worth much less, no longer representing half your total savings. You decide that since bonds are performing better (which, as we’ve seen, they did during the years following the recent financial crisis), so why not move more of your remaining money in stocks over to bonds? If you do, you will no longer be diversified and will be overly invested in bonds. You will lose lots of your hard earned savings when bonds tank.

Case 2

Let’s start again with 50% in bonds and 50% in cash. As the stock market crashes this time, you try to maintain your original diversification target of 50/50. So as the value of the bonds rise relative to stocks, you continue to sell bonds (at a profit) and buy more stocks (which are “on sale”). In my mind, this approach is vastly superior to the first case.

Case 3

Beginning again with an even split, this time when the stocks plunge in value, you sell the rising bonds at a profit and allocate even more than 50% to the depressed stock market. In this case, you are deliberately becoming less diversified but skewing your mix of assets in favour of the asset class that’s declined. This is the maverick’s approach.

Are you having trouble getting your head around this stuff? Think of your money as water in a glass, and the glass is half full. If you keep drinking a little from the glass (Case 1), you’ll eventually have nothing. If whenever you take a drink you add back enough water to take it back to half full, the level in your glass never changes (Case 2). Alternatively, you may take a drink now and then, but you always add more water than you drank (Case 3) so that eventually your glass will be full.

Notice that you could apply all three strategies to a portfolio of two stocks, or two mutual funds or hedge funds, or two different exchange-traded commodity funds. In fact, you can easily have more than two asset categories—more dimensions to contend with, but essentially the same idea.

The important thing is that the different securities must behave differently at different times so that your portfolio is really diversified. It doesn’t work when they move together.

About Mal Spooner

Malvin Spooner is a veteran money manager, former CEO of award-winning investment fund management boutique he founded. He recently authored A Maverick Investor's Guidebook which blends his experience touring across the heartland in the United States with valuable investing tips and stories. He has been quoted and published for many years in business journals, newspapers and has been featured on many television programs over his career. An avid motorcycle enthusiast, and known across Canada as a part-time musician performing rock ‘n’ roll for charity, Mal is known for his candour and non-traditional (‘maverick’) thinking when discussing financial markets. His previous book published by Insomniac Press — Resources Rock: How to Invest in the Next Global Boom in Natural Resources which he authored with Pamela Clark — predicted the resources boom back in early 2004.
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