Whenever worries about inflation begin to creep into the market the topic of commodities as an inflation hedge comes up. The theory is that as the economy recovers so does demand for resources, particularly oil and certain metals, which drives up commodity prices. Since a rapidly growing economy quite frequently leads to a bias toward higher prices, the hope is that gains in long commodity positions will offset losses due to inflation.

While I have no argument with the underlying economics here, I do have an issue with using commodities indiscriminately as an inflation hedge. I would argue that commodities are volatile, risky assets that should only be held in the context of a higher risk tolerance, speculative position. Specifically, here are some of issues with using commodities as an inflation hedge as opposed to considering them merely another speculative investment.

Commodities are speculative investments: I know there are many out there who will disagree with this point but I believe that commodities are by nature speculative. You make a return in the commodity market by selling a position for more than you paid for it (or buying one back for less than you sold it for) period. That barrel of oil or block of gold you own pays no dividend or interest and doesn’t have any earnings to grow. You are betting you will make money strictly on a basis of the change in the price of the underlying commodity, in other words speculating. This is not investing so call it what it is, speculation.

Commodity markets are volatile: Even if you missed the $40 to $140 to $70 per barrel rollercoaster of oil prices over the past 2 years you undoubtedly have noticed the rapidly changing price of gasoline over that period. Commodity prices are volatile, in fact even well managed commodity funds are very volatile. The largest commodity fund in existence, PIMCO Commodity Real Return Strategy has a three-year standard deviation of about 30. For a bit of context, that's less volatile than the typical emerging-markets equity fund. However, it's about 50% more volatile than a total U.S. stock market index fund and more than 3 times as volatile as the average TIPS fund.*

Commodities’ correlation to inflation is weak, especially short term: When oil prices were experiencing their rollercoaster ride in 2008 and 2009 inflation was basically flat or falling. Gold also gyrated widely as liquidity dried up and speculators chased in and out of positions during a flight to quality assets. That doesn’t look like an inflation hedge to me.

With commodities timing is everything: One needs to only look at the scores of unwary investors who happily bought oil funds or ETFs when oil was around $100 per barrel to see that timing is everything. It felt great as oil traded up toward the highs of $140 per barrel or so but only a few months later the price of a barrel of oil was back down well below $100 and has not come close to that level since. Was it possible to make money? Sure, but it was all about timing. Based on the sentiment in the press and blogs at the time you’d very likely have gotten the timing wrong like many others did.

Commodities are generally not tax friendly: Because commodity funds and ETFs rarely are prepared to actually own the underlying commodity, they need to roll over their positions (usually futures contracts) before delivery. This tends to create only short term losses and gains which are taxed at ordinary income rates. Get the timing wrong here and you can really get hurt. People who bought oil funds with oil at $90-100 per barrel faced big short term gains as oil shot higher and the funds rolled over their delivery contracts. But, if they held onto the position as oil prices fell they took those short term taxable gains while facing a big loss of principal.

For the most part investments in commodities are neither a very good inflation hedge nor a solid earning investment. What they are is a speculative investment with enough volatility to create opportunities to make (and lose) money. Participate in this market sector if you think it’s appropriate but only do so with a realistic view of the risks.

Randy Gridley

January, 2010

* Morningstar, Commodities, Look before you Leap, Christine Benz, 2/26/10