Commodities: A Cautionary Tale

For the last couple of quarters, commodity investments have captured intense investor interest, with many of our own clients having inquired as to our stance on inclusion given their latest rise in popularity.

Commodities have developed a reputation for providing a hedge against inflation and an apparent negative correlation to equities. Further research into this subject reveals that no such advantage proves out. A compelling study by former USC finance professor, Truman Clarke details the lack of substantiation for the bold claims made by commodities proponents. IFA has detailed that study and you can read the article by clicking here.

Deservedly so or not, commodities assumed their moment in the spotlight, prompting a need for further explanation as to what commodities are and the risks associated with them.

Quite simply, a commodity is a hard asset, an item that is purchased on the hope that an increased demand or a decreased supply for the item will cause its value to increase. Commodity investments differ from stock investments in that companies, on average, make about 10% of profits per year. Under most conditions, their stock value is expected to increase approximately 10% a year, on average, as well. The expectation of price appreciation for commodities is not based on profits, but rather on supply and demand. In short, commodities do not engage in capitalism.

Recently, the rapid rise in oil prices, based on supply fears and political tensions, caused rampant speculation in the futures markets.  Oil futures were driven from $100 to $140 a barrel in a few short months, and investors loaded up on them, sending prices even higher.  

The laws of supply and demand do ultimately prevail, however. Oil prices have recently retreated, and investors who purchased futures contracts have paid dearly for price speculation.

Even worse investment experiences have occurred for commodities investors who elected to invest in the Ospraie Fund, a hedge fund that was -- until just a couple of days ago -- one of the biggest players in commodities. That is, until the fund manager announced that it would unexpectedly fold its largest fund, the result of significant, precipitous, and unrecoverable losses the fund suffered in a single one-month period.

According to a Wall Street Journal article, dated September 3, 2008 titled “Ospraie Closes Largest Fund As Commodity Losses Swell”,  “The Ospraie Fund fell 27% in August alone due to bets on oil, natural gas and structured products, and the fund has been selling off its holdings over the past three weeks, possibly contributing to a decline in commodity prices. The fund, whose assets peaked at $3.8 billion late last year, is the biggest run by Dwight Anderson, a veteran commodities investor.”

That statement quoted from the Journal is pretty incredible. A decline in commodity prices was actually set in place by an overextended hedge fund. Perhaps the most disconcerting aspect of the story is that it details massive losses that were incurred by Anderson who is described as “a veteran commodities investor.” 

Anderson’s letter to shareholders stated, “The losses were primarily caused by a substantial selloff in a number of our energy, mining and resource equity holdings during a six-week period characterized by some of the sharpest declines in these sectors in the past ten to twenty years.” Anderson goes on to state that shareholders will not receive the sum total of what’s left of their assets until the end of the year “because the assets are hard-to-sell illiquid investments.”

Certainly, this commodities investing tragedy is made infinitely more complicated by the fact that it involves a hedge fund. Hedge fund managers are not regulated by the SEC, they are not held to disclosure standards, and they are handsomely paid in both a percentage of assets and performance. In other words, they are encouraged to take incredible risks with other peoples’ money because they have everything to gain and little to lose. IFA has summarized the hazards of hedge funds and you can read the summary here.

The simple, yet painful lesson for investors remains a cautionary tale regarding commodities speculation coupled with hedge funds investing. When you place a bet on short-term price movement in commodities, or you pay a hedge fund manager to place such speculative bets, it is only a matter of time before your luck and money run out. 

Index Funds Advisors matches individuals and institutions, including corporations, foundations, endowments and perpetual care entities, with risk-appropriate blends of indexes that have shown to deliver risk-optimized returns over time.  To learn how you can implement a low-cost, risk-appropriate, passive rebalancing indexing strategy, click here.