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ETFs Gone Wrong

14 Oct 2019

 

When ETFs first became popular about 15 years ago, it was akin to a gold rush, in that everything and anything could now be packaged into these lovely funds that could so easily be bought and sold on an exchange. For some asset classes and strategies this has worked really well, and one can’t really argue with more than $4 trillion in assets under management that are now held in ETFs. But this post isn’t so much about the merits of holding assets in one investment vehicle or another, but rather whether it makes sense to buy and hold commodity ETFs.

 

On the face of it, diversifying traditional stock and bond portfolios with another asset class makes total sense. Running any sort of correlation analysis, will clearly indicate that there are benefits in doing anything other than just holding two assets. But the numbers are misleading and also make it quite clear that just relying on static analysis is a dangerous game. Lest we forget, that eating ice cream and drownings are highly correlated for obvious reasons, but that doesn’t mean that if I eat ice cream I am going to drown.

 

The real reason that you can’t buy and hold commodities, is that unlike stocks and bonds, things that come out of the ground generally need to be consumed or otherwise used for there to be a benefit. A ton of steel is worth a lot less than the elevator we make from it. Moreover, many commodities are perishable, and you wouldn’t buy a barrel of wheat and put it in your basement for twenty years, hoping that the price may go up. And therein lies the rub, just because we have found a way to speculate on commodity prices through the use of financial derivatives, doesn’t mean that they don’t have to be physically stored somewhere.

 

It is a popular urban myth that a trader once forgot to sell his forward position in a large quantity of copper and then promptly had to take delivery of several tons of the metal at his registered address, which happened to be his home. Fact is, to get exposure to any type of commodity, the storage and administrative costs are implied in the price and the longer you hold your position, the higher the costs. Which is why you would never see oil going up in the same fashion as the S&P 500 index, or did you ever wonder why oil has underperformed the US stock market by 4350% since 1980? So, you may want to have a look at all of those wonderful commodity ETFs, that have probably only ever gone down in price since you bought them. There really is no hope that they will ever produce the type of returns you had hoped for and the diversification benefits leave much to be desired.

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