Not Another Investment Podcast
Understand investing beyond the headlines with Edward Finley, sometime Professor of Finance at the University of Virginia and veteran Wall Street investor.
Not Another Investment Podcast
Hedging Against Inflation: The Role of Real Assets (Commodities) (S1 E18)
Unlock the mysteries of real assets and their touted powers as inflation hedges with me, Edward Finley, on Not Another Investment Podcast. Together we explore the role of real assets in a portfolio. We develop three categories of real assets, like commodities, production means, and infrastructure. By breaking down these complex relationships, we find that some "real" assets are more real than others. You'll gain insight into not only the potential safeguards against inflation they offer but also the intricacies of investing in assets with their unique risks and liquidity challenges.
Venture into the fascinating realm of commodity futures, there typical way investors gain exposure to commodities, and understand how the dance between futures prices and spot prices reveals much about the health of our economy. We'll clarify the concepts of backwardation and contango, where the roles of hedgers and speculators pull the strings behind the scenes, crafting the market's momentum and influencing the all-important roll yield. This nuanced understanding is key for those looking to tap into commodity spot returns without the hassle of physical inventories, and I promise, it's a topic that will sharpen your investment acumen.
We'll put theory into practice by analyzing how commodity futures, particularly corn and oil, have performed through the lens of historical data. From the shockwaves sent through oil markets during COVID-19 to the long-term perspective on its efficacy as an inflation hedge from 1997 to 2023, this episode is a goldmine for enthusiasts and experts alike. And remember, for more in-depth resources, charts, and a chance to continue the conversation, visit Not-Another-Investment-Podcast.com. Your engagement is not just welcomed—it's essential in fueling our journey to demystify the investment world.
Episode Notes: https://1drv.ms/p/s!AqjfuX3WVgp8unnB8BqkHQD1_6HG
Thanks for listening! Please be sure to review the podcast or send your comments to me by email at info@not-another-investment-podcast.com. And tell your friends!
Hi, I'm Edward Finley, a Sum-Time Professor at the University of Virginia and a Veteran Wall Street investor, and you're listening to Not Another Investment podcast. Here we explore topics in markets and investing that every educated person should understand to be a good citizen. Welcome to the podcast. I'm Edward Finley.
Speaker 1:Well, we turn our attention now to the last of our asset classes, and that is real assets, and, in particular, we'll spend this episode talking about commodities and the next episode talking about real estate. So let's just take a big step back and understand what we think we mean when we say real assets. So I'll offer up a definition. We'll take it apart, see if it makes any sense. I think real assets are those whose returns are positively correlated to inflation and are roughly independent of equity and bond returns, and they're expected to deliver positive real returns. So why do I think that? Well, if real assets have any use in a portfolio, it's probably to act as a hedge against high inflation, and you'll remember we talked about in the past, where inflation expectations dominate, asset pricing, stocks and bonds move in the same direction, which is to say down, and so to own a real asset would mean to own something that, when there's positive inflation, that we expect positive returns. So that's where we get the positively correlated to inflation and then independent of equity and bond returns. Because essentially, if we have an asset that is positively correlated to inflation, the best we can hope for is independent from equity and bond returns. And then the last part of my definition was expected to deliver positive real returns. So why do we say that? Well, that's because if an asset is designed to be a hedge against a certain risk in a portfolio, which is what the word real sort of connotes it seems to me that it's got to do more than just not be correlated.
Speaker 1:We talked about this a long time ago in an earlier episode, when we discussed the notion of the capital asset pricing model and how. What's important is not just volatility, but volatility and co-movement. That's all well and good, but at the end of the day, we're investors, and so rocks may be non-correlated with stocks and bonds, but rocks don't have any expected real return, so we wouldn't want to own them. So it's not enough to say positive correlation to inflation, it's not enough to say independent of equity and bond returns. I think we also have to say that we expect to earn positive real returns for these assets. As we discussed, in the last 30 years, inflation expectations have become much less relevant in asset pricing as the market's confidence in the Fed's ability to maintain stable inflation and avoid monetary surprises has predominated, and that means that growth expectations have dominated asset pricing. But it's rather important to know that, as we've seen in the last three years, there are moments when inflation expectations do dominate asset pricing, and so that's the moment that you'd want to own real assets, particularly when inflation expectations dominate asset pricing. Stocks and bonds are both moving down. It would have been rather nice to own real assets in 2022 and maybe even in parts of 2020. So let's take an overview, then. That's the role, that's what real assets are. Let's sort of take an overview, a big picture overview, to break it down into some components that will be easier for us to handle what I would say that real assets.
Speaker 1:One category of real assets we can think about is what I'll call productive real assets. These are the inputs to the economy. So basically, these are commodities oil, wheat, sugar, iron and the assets that produce them farmland, timberland oil and mineral rights. So these are the basic inputs of the economy and the assets that produce them. I think of these as productive real assets. In general, we find that most of these assets, other than oil, show very little correlation with inflation and so they sort of fail. The first test, the first test of a real asset, it seems to me, is that it's going to be positively correlated to inflation With the amount of oil. It shows very little positive correlation to inflation and because of how these commodities trade, the returns that you earn are not merely for the change in price of the input We'll talk about that a fair bit later on in the episode but rarely, or barely do these assets earn positive real returns. So productive real assets, I would argue, while we think of productive real assets as in the most fundamental sense real assets, they fail as an investor to sort of suit the bill of why you would own real assets. They're very little correlated to inflation and they seem to rarely earn positive real returns. The second main category are what I'll call infrastructure real assets. These are the assets that facilitate the operation of the productive economy here. Think toll roads.
Speaker 1:Commercial real estate, residential real estate, particularly multifamily residential real estate or rental real estate. Commercial real estate returns we find are moderately correlated with inflation and are independent of stock and bond returns. They also tend to earn positive real returns, so that's rather encouraging. So commercial real estate would seem to fit the bill in terms of what we're looking for when we're talking about real assets.
Speaker 1:Commercial real estate is subject to enormous idiosyncratic risk. Think of the old phrase, right, what's the most important thing in buying real estate? Location, location, location. That's very idiosyncratic. It suggests that the property on the corner of Madison and 38th Street has an entirely different profile than the property on the corner of Madison and 28th Street. There's real real differences in where that real estate is, even if the building and the amenities and all of the great stuff are identical, and that means that it's very hard to diversify that risk, because idiosyncratic risk is not diversifiable by definition and it means that it tends to suffer from illiquidity. Now, why I mention that is because we're gonna be looking at index data for commercial real estate when we get to that in our next episode. But index data is not investable. I can't own all of those properties. I can't even buy a fund that owns a lot of those properties, and so we wanna be very careful when we think about the data, to be careful in understanding how we would execute it in real life All right. So category one productive real assets. They don't really sound like real assets and they don't sound like they're terribly interesting in portfolios. Infrastructure real assets. The example I chose is commercial real estate. Certainly sounds like a real asset the way we've defined it, but kinda difficult to invest in because of its size, kinda difficult to diversify and probably significant illiquidity risks.
Speaker 1:And then the last category precious metals. Precious metals are rare by definition. They're rare and they have value because people say they do. Think gold, right, silver. These are classic precious metals. What is it about gold that makes it precious? It's not just its rarity. There are lots more metals that are rarer than gold. Yet we ascribe value to gold that we don't describe to other metals. And so what? I hope you're hearing, as you hear me, say that they're rare. Sure, there's a limited amount of it, but they have value because we say that they do. I hope a lot of you are thinking of things like Bitcoin. It would be very interesting to think about Bitcoin in the category of precious metals, not because it's like gold or silver I don't think it is at all but because it's limited and it has value because we say it does. I mean, I've never seen a study on this topic, but I think it would be a very interesting question to look more closely at Over a very long time period I eat like a hundred years the precious metals are moderately correlated to inflation, it's true, but at shorter and I should say they, on average they earn positive real returns.
Speaker 1:So we have some sense that they might really fit the bill in a portfolio when we talk about them as real assets. But when we look at shorter time horizons not a hundred years but maybe 20 years we find that their returns are independent of inflation, as well as stock and bond returns. So they're not really correlated to inflation and they still earn positive real returns. But what's interesting is, if you look at rolling 20 year horizons so sort of 20 year period followed by 20 year period followed by 20 year period what we see is there's a strong negative correlation between the next 20 year periods returns and the first 20 year periods returns. And that strong negative correlation suggests that maybe these assets are not real assets as much as they are a proxy for inflation expectations or fear. So they might not correlate to inflation. But that's not because they're not good diversifiers, but because if inflation doesn't materialize, it's of no use, whereas these assets tend to attract interest and their price changes based on expectations of inflation, whether or not it comes true. So I think what's the takeaway if we bundle these up in the way that I've suggested, is that some real assets are more real than others, and so we have to kind of think about it carefully when we're analyzing them.
Speaker 1:In this podcast, we're gonna talk about commodities, so let's turn there. Let's go ahead and talk about the commodities. Let's go ahead and talk about the commodities. As I said, commodities are the productive inputs of the economy and I'm gonna put into the commodities bucket even though I didn't a moment ago, I'm gonna put those store of value assets like gold and silver, just because I think it'd be useful to think about them in the same moment.
Speaker 1:Commodities well, you can buy commodities on the spot market. Typically, delivery is in 30 days. Like other assets, you can purchase a commodity and hold it for future sale. But the return that you earn on that commodity, if you think about it, is not just gonna be the change in the price, but it's gonna be the change in the price less the cost of storing the commodity and the cost of financing it. And the cost of financing it might be that you literally have to finance it, so there's a financing cost. But the financing cost may just be opportunity cost. If I use my money to buy corn, bushels of corn, I don't have it to buy equities, and there's an opportunity cost to that. And so when we think about returns to commodities, we wanna think in terms in the spot market, we wanna think in terms of the change in price minus the cost of storage and the costs of financing. But of course we might need the commodity next year and we're just worried about the price going up. Or I don't need the commodity at all. I'm an investor and I wanna speculate about what the price of that commodity is going to be down the road. In both of these cases we wouldn't necessarily want to buy the commodity and hold it, and that's mainly because of just the complexity and the pain in the neck of doing that. We might instead look to the futures market and so, like other securities, one can buy and sell commodities futures.
Speaker 1:We talked very, very briefly a long time ago when we talked about how securities trade. We talked about futures, and here we're gonna get a little bit deeper because it's relevant to understanding how they work in owning commodities. So, generally speaking, investors in commodities futures seek to earn a return on the price of the commodity. That's the whole goal, right? But because of the way futures trade more on that in a minute investors will have to earn return minus or plus something called role yield. And again, I'll explain all of that in a minute. But I just wanna communicate that where buying commodities on the spot market, we'll have a return equal to the change in price, minus the cost of storage and the cost of financing. The rate of return in rolling futures contracts in a commodity will be the change in the price of the commodity, plus or minus something called the role yield. Well, let's talk about the price of a futures contract, and here we're gonna discuss the concepts of backwardation and contango.
Speaker 1:John Maynard Keynes, very famous economist of the 20th century, described how the normal state of a commodity's futures market involves a balance between hedgers and speculators. So hedgers are risk averse. Think these are the people who sell commodities, right? So I am a farmer and I grow wheat and I sell wheat. I'm a farmer and I grow corn and I sell corn. I'm gonna be as what Keynes would call a hedger. I'm risk averse and so I don't want to suffer a decline in the price of my commodity when I harvest it next year.
Speaker 1:So I'm typically going to be short on a futures contract, meaning I sell the futures contract to someone else. I promise to deliver the corn in the future. I'm gonna be short, but in order for the market to clear then there are gonna have to be speculators who are long. Speculators are not gonna be long unless they believe that the commodity price will rise Right. Think about it. If you're just speculating on price, you're an investor, so you're very happy to buy a corn futures contract. You don't wanna buy a corn futures contract unless you think what, unless you think the price of corn is going to go up higher than what the contract price is, and so they will demand a discount to the current spot price before they're willing to buy the contract. That's a speculator.
Speaker 1:And so Keynes described how you could look at any commodities market and you could see the mix of hedgers, speculators, and then you can understand how this market will clear and, in his view, the state of the market, where the futures price is lower than the spot price, is, to say, as Keynes described it, he thought the regular state of commodities markets is more speculators than hedgers means that the futures price will be lower than the spot price, and that's called backwardation. And there's, if you have access to the slides which you'll see, a link in the notes to the podcast you can take a look. If you don't have it, don't worry about it, it's okay. But there's a pretty straightforward graphic which shows you sort of the futures price of a contract today, and I'm looking at the normal backwardation example of $40. And the spot price, which in this example, to keep it simple, just stays the same across time at $60. And since the futures price of $40 is less than the spot price of $60, we describe that as backwardation. More on that in a minute.
Speaker 1:Another 20th century economist, hicks, pointed out that Keynes was right, but that there are some commodities markets in which hedgers are net long. So here, think about the buyers of commodities that we mentioned a moment ago. They want to lock in a price and they're willing to pay a higher price for a contract to lock in delivery than would otherwise be in the spot market. Right, they're at risk of verse two, but their version of hedging Keynes was thinking about the seller of the commodity. The buyer of the commodity might also be engaged in hedging because they know they need wheat next year and they don't want to pay more for it next year, and so they'll be long. The futures contract they will buy a futures contract for delivery of wheat a year from now. Well, they're willing to pay a higher price versus the spot market and, in order for the market to clear, speculators are therefore going to sell futures contracts at a premium to the spot price. And so when we have a market in which the futures price is higher than the spot price, we call that contango. And again, there's a graphic, if you want to see it, that shows how, if the spot price is $60 and the futures price is $90, you're in the state of contango.
Speaker 1:Why do we call them backwardation and contango? I haven't got a clue. It's just what they're called. I wish I could explain it. I've searched and searched, and if any of you finds a good explanation for why we use those phrases, please email me. I'd love to hear about it.
Speaker 1:So what we find in general is that some commodities typically have more producing hedgers than consuming hedgers. That would describe the oil market, for example, and the futures market for that commodity is typically going to be in backwardation. Other commodities typically have more consumer hedgers than producer hedgers. A good example is corn, and therefore that futures market will typically be in contango. However, it's important to note that those typical states of the market are not the always state of the market, and what will change is the relative mix of hedgers, whether the hedgers tend to be producers or the hedgers tend to be consumers, and who predominates in that field. The speculators are the ones that will always make the market one way or the other. It's also important to note that investors increasingly have been long in the futures market for commodities because investors perceive commodities as good hedges for inflation, like oil, and that's resulted in the fact that if speculators move back and forth into and out of these commodity futures markets depending on their inflation expectations, that will also change the mix of hedgers on each side and speculators, and that means that sometimes in shorter time intervals, we will see a commodity be the opposite of what its typical state is.
Speaker 1:All right. So that's the idea of how futures markets price futures and it introduces the notion of backwardation, where the futures price is below the spot price, typical for when the market has a predominance of hedgers, that are, producer hedgers, and then some markets in which the futures price is higher than the commodity spot price, and that's where consumer hedgers tend to dominate. Well, what is this idea of role yield? I introduced this sense that the return as an investor in commodity futures is going to be the change in price of the commodity, plus or minus the role yield. Well, investors who want to earn the spot return in the commodity but don't want or can't hold the inventory, will buy futures contracts. But they don't want the commodity. The investor, by definition, is a speculator. They don't want delivery of the corn next year and so, as the contract nears maturity, they will sell the contract to someone who wait for it, wants corn.
Speaker 1:But, as you might imagine, as the contract gets closer and closer to the maturity date, the price of the future, its price, the security, the futures contract, will converge on the spot market price. So, if we take a simple example, if we have a market that is in backwardation, so the futures price is 40, the spot price is 60, and it's a one-year contract. As we approach the maturity of the contract, assuming that the spot price doesn't change, it stays at 60, the value of the futures contract will get increasingly closer and closer to 60 until the metaphysical moment before maturity it will trade at the spot price and the investor then will sell right before maturity and reinvest in another one-year contract, because as an investor, if you want exposure to that commodity, you want long-term exposure, not just one year. Well, let's take the example of backwardation then. So when the futures price is typically lower than the spot price, the investor is going to sell the contract at a higher price than they paid for it and then roll those proceeds into a new contract that's lower than the spot price and sell it at the higher spot price, and so on and so on. And so with backwardation we would expect to earn some positive return for the appreciation of the futures contract.
Speaker 1:In contrast, where a commodity is in a typical state of Contango, the futures price is higher than the spot price. I buy the futures for $90 and the spot price is 60. And as the contract gets closer and closer to maturity I will sell it. But I'm going to sell it now for just a little more than 60. So I'll have a loss of about 30 and then I'm going to reinvest in a new futures contract at 90. In Contango, the role yield will be negative.
Speaker 1:So let me give an illustration of this, because I think a numeric illustration will help us understand the idea a little bit more. Again, there are slides for you if you're a visual person, but if not, I'm just going to talk through the numbers. I think they'll make sense. So let's start with corn. And what we know about corn is that corn is typically in a state of Contango, that is, corn is typically one of those commodities where consumer hedgers predominate producer hedgers.
Speaker 1:As of March 18, 2024, the three-month futures contract for corn was trading at $4.49 a bushel and the spot price was $4.74 a bushel. So the futures contract is trading below the spot price and therefore that moment, on March 18, 2024, the three-month corn future was in backwardation. If I bought a one-month contract and rolled it and bought another one-month contract and rolled it and bought another one-month contract, at least for that first roll, I would have a positive return because I've got this positive roll yield. But if we look at more typical contracts, you wouldn't roll one-month contracts, you would roll one-year contracts. So again, as of March 18, 2024, the one-year futures contract for corn is trading at $4.90 a bushel and the spot price is $4.74 a bushel. That is, the futures price is higher than the spot price, which is contango, and that's the typical state of the corn futures market.
Speaker 1:And we can see graphically. I provided you with a graph of all of the futures prices the spot price and all of the futures prices as of March 18. And you see that the line it's squiggly but it's largely upward sloping, and upward sloping suggests that the futures price is higher than the spot price. All right, let's take a look at oil in contrast. So in the case of oil, we can see that as of March 18, the three-month contract is trading at $80.14 a barrel and the spot price is $81.04 a barrel. So oil one-month oil is in backwardation. Again, we can look at one year to get a better sense whether the forward three-month contract is maybe just a little deceptive. And if we look at one year, we see the same thing. We see that the spot price is higher than the futures price and that's because oil is typically a market in which producer hedgers are much more active than consumer hedgers and that means it's typically in a state of backwardation, which is currently the case, but it's important to note, back in March of 2020, so we're talking about the onset of COVID the three-month contract was trading at $32.83 a barrel and the spot price was $29.21 a barrel. In other words, contango, the futures price was higher than the spot price. And so I just want to make the point that while oil is presently in backwardation on March 18, 2024, and while it's generally in backwardation, it doesn't always have to be Right then.
Speaker 1:So what is the return profile that we get in owning these kinds of commodities? Remember that the total return equals the spot return plus or minus roll yield, and, depending on the commodity, the roll yield can have an effect on the investor's total return, in some cases significant, in other cases not so significant. So let's just look at the data historically to see how this plays out. We'll start with oil. So if we look again at our typical period, 1997 to 2023, returns on oil seem like a reasonably good inflation hedge. So the correlation to inflation was 48% during that period. So that's pretty good inflation hedge. And we also see that oil in the spot market was roughly independent of US equity and interest rate risk. It was a 14% correlation to US large cap stock and a negative 16% correlation to the tenure. We see roughly the same in the futures market. Also, in the futures market we see that the correlation to inflation is 54% and roughly independent of stock and bond returns.
Speaker 1:The compound return in the spot market for oil was 4%, so that meant that it did earn positive real returns, but pretty modestly positive 1.5%, and so I would say in the aggregate on the spot market it looks like a reasonably good real asset to own, but a kind of complicated one to own because you'd have to finance and store it. So when we look at the futures market, we see that the futures return rolling three-month futures contracts resulted in an average annual return of 4.2% as opposed to 4%, and so that implies a positive role yield of 22 basis points, and that's not huge, but it's something material and it's consistent with the market being in a typical state of back-redation. It also turns out if you look at sub-periods you find that it stays pretty consistently the same, and so the other thing that we observe is that the futures market volatility is a fair bit lower than the spot market volatility 35% as opposed to 41%. A couple of things should jump out at us from that information. The first is that is whopping high volatility to earn 4% returns, and so the information ratios here are spot 1, 2, and spot 1, 0. That's really rather dismal, and so you need a real asset to be earning positive real returns, positively correlated with inflation, independent of stock and bond returns, because you're definitely not earning return for volatility. That is a bumpy ride to get you your 4% return or your real return of 1.25%. But the fact that the futures market is lower volatility than the spot market suggests that there are fewer speculators in the futures market than in the spot market, which is consistent with what we might expect.
Speaker 1:Let's turn now to corn prices. Let's see how that pans out. Well again, returns on corn in the spot market shows only a very modest positive correlation to inflation of about 12%, but, independent of stock and bond returns, negative 2% correlation to stocks and a 2% correlation to the 10-year treasury. So far, so good. But the compound return on corn during that period was 2.25%, so that didn't even earn positive real returns. Inflation during that period was 2.5%, so that was negative 25 basis points a year real return. And still it's not terribly practical to buy corn and hold it for resale. So we might roll three-month corn futures If we rolled three-month corn futures, we earn 2.3% a year as opposed to 2.25%. In other words, the roll yield was seven basis points a year, which is not quite consistent with typically being in Contango, but at least for that period was slightly positive. And, like oil futures, the volatility in the three-month corn futures market was higher than the volatility in the spot market, suggesting that there are fewer speculators in that futures market.
Speaker 1:Last but not least, let's just take a look at gold and silver. I said we would include them here just for completeness. It's not terribly difficult to own gold and silver for investment, so the costs of storage are really de minimis and typically you don't need to finance them. So we could just look at the spot market for silver and gold. For the same period, 1997 to 2023, gold and silver have not been particularly good real assets. But they may be perfectly good assets to own, just not in the sense of what we think a real asset is supposed to deliver.
Speaker 1:So in the case of silver, correlation to inflation was 8% from 1997 to 2023, so certainly not positively correlated to inflation. Gold 3.7%, really independent of inflation. Moreover, silver was much more highly correlated to equities 25% than we might expect to see gold not so much, only 6% correlation. In contrast, silver not terribly correlated with the 10-year 6%, but gold positively correlated to the tune of 27%. So we see they each kind of fail the basic test of positive correlation to inflation and independent of stock and bond returns. They fail it in different ways, but they nevertheless fail it. Yet they both earned positive real returns.
Speaker 1:In the case of silver, the average return was about 6% a year. In the case of gold it was about 6.6% a year. So positive real returns. So on that score, that's great, but, like the other commodities, highly, highly volatile 28% for silver and 14% for gold. Gold's information ratio, therefore, is a little closer to equity information ratio. It's 0.46, and historically equities is about 0.56 or 0.6. And silver had a 0.22.
Speaker 1:So you're not really owning this commodity for its return per unit of volatility, but I would argue, if you are owning it for any other reason, I can't see that reason. It's not because it's correlated to inflation, it's not because it's independent of stock and bond returns, and so it's just a curiosity to me why one would want to own something that earns so little return for so much volatility. I suppose the main advantage to owning either would be the lower or moderate correlation to equity and interest rate risk and the fact that it earned positive real returns, but it's not entirely obvious to me that that's a good enough reason to own it. So I'll stop there with the first section of real assets commodities and when we come back next time we'll pick up the second really big category of real assets commercial real estate. Until then, I look forward to talking to you next time.
Speaker 1:You've been listening to Not Another Investment Podcast hosted by me, edward Finley. You can find research links and charts at NotAnotherInvestmentPodcastcom, and don't forget to follow us on your favorite platform and leave comments. Thanks for listening. You, you, you, you. You.
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