The Problem With Commodities Indexing

Is there a more honored role to play in any gathering of practitioners than the designated skeptic? No, and that is why I was so flattered to occupy such a slot at last week's "Portfolio Diversification With Commodities" conference in London. Skepticism is just another word for intellectual honesty, a commodity in short supply whose price never seems to rise. What does that static price imply for the demand for intellectual honesty?

For what little it is worth, the actual title of my presentation was "A Sceptical View," but the British did me the favour of using the American spelling.

A central problem faced by global investment managers right now is a growing demand for stable and long-term investment returns -- think pension funds, life insurance and Social Security -- and a growing shortage of reasonable sources from whence to derive them. Gone, for the time being, are the days when anyone could get double-digit returns in stocks simply by showing up and declaring fealty to the principle of long-term investing. A duplication of the fixed-income returns of the past two decades is virtually impossible mathematically, and real estate, as you may have heard, is not cheap.

More Risk Please, Sir

Just as cats are attuned to horizontal motion and sharks to blood in the water, investors are attracted to past returns, and the financial services industry is designed to provide products to satisfy investors' demands. There is nothing inherently wrong with this, as long as investors understand the perils of chasing return and the sell side understands and cares that it may not be doing its customers a favor by taking an idea with recently successful performance and beating it into the dirt. While neither development is likely to occur while humans trod the planet, we all must remember that the world can be changed in small ways one step at a time. Otherwise, what's the point?

The recent success of commodities at the very time when other investments have hit a wall has produced the usual Pavlovian reaction on Wall Street. Many of the arguments presented on behalf of commodities as an investment class were the same as those presented at a similar conference held last December in Geneva, but with some notable and telling differences.

Several speakers noted that the entire total return in commodities since 1994 can be attributed to crude oil. Not some of the gain, all of the gain. However, much of that gain until 2003 did not come from price appreciation but from the accumulated capture of backwardation in crude oil futures. This gain, which is created by producers' demand for insurance, has disappeared as more and more long-only indexed commodity funds entered the market, as discussed here in April.

The failure of this return source, predicted here in that December column, opened the way for some tap-dancing worthy of Bill "Bojangles" Robinson. Proposals were offered to change the monthly contract rolls from the 5th through 9th days of the month to the 1st through 4th days, to roll from the front month to anything but the second month, etc.

No one admitted the problem was a bad idea whose folly had been shown; no, the problem could and would be solved by modern data-mining techniques. There's no crying in baseball, and there are no mulligans in investing. If you cannot present a hypothesis a priori, provide theoretical justification for it and then confirm the theory with empirical data ex-post, you are a guiding light for the gullible, nothing more.