Commodities And Investment Mistakes Even Smart People Make

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The behavioral finance literature is a tale of woe, filled with investment mistakes even smart people make because they are subject to all-too-human biases. Among the most common mistakes are:

Recency bias: the tendency to overweight recent events/trends and ignore long-term evidence. Engaging in resulting: judging the quality of a decision based on the outcome instead of the quality of the decision-making process. Nassim Nicholas Taleb, author of “Fooled by Randomness,” provided this insight into the right way to think about outcomes: “One cannot judge a performance in any given field by the results, but by the costs of the alternative (i.e., if history played out in a different way). Such substitute courses of events are called alternative histories. Clearly the quality of a decision cannot be solely judged based on its outcome, but such a point seems to be voiced only by people who fail (those who succeed attribute their success to the quality of their decision).” Hindsight bias: the tendency, after an outcome is known, to see it as virtually inevitable. Considering returns of a strategy in isolation: judging performance on how the addition of the strategy impacted the risks and returns of the entire portfolio-correlations and volatility matter as well.

Unfortunately, all four of these mistakes combine to cause investors to err when judging the performance of commodities and considering whether to include exposure to commodities futures in their portfolio.

The Role of Commodities Futures in a Portfolio

Unless an investor believes that on average a basket of commodities futures (CCF, or collateralized commodity futures) will have persistent backwardation (allowing investors to benefit from buying futures at lower than spot prices), the only real return investors should expect from their investment is the return on the collateral (for example, TIPS). Thus, the reason to consider adding exposure to CCF is as potential portfolio insurance, not for high expected returns. For example, because commodities are a source of inflation, CCF tend to act as a hedge against unexpected inflation-over long periods the correlation of returns between commodities and inflation has been positive, and the longer the period, the greater the correlation. CCF also tends to act as a hedge (insurance) against negative supply shocks (such as the oil embargo of the 1970s and Russia’s invasion of Ukraine)-which can be negative for both stocks and bonds-or as a hedge against positive demand shocks that can cause inflation to rise-which is negative for bonds (especially longer-term bonds). On the other hand, CCF should be expected to perform poorly if we experience either positive supply shocks (e.g., the technological innovations of deepwater drilling and fracking) based on historical trends, which would be good for stocks and bonds, or negative demand shocks (e.g., the Great Recession and COVID-19), which would be negative for CCF and equities but good for bonds (especially longer-term bonds).

Note the economic regimes-negative supply and negative demand shocks-when CCF and longer-term bonds should be expected to be negatively correlated. This is important from a portfolio perspective, as the risks of the two mix well. Thus, investors considering adding CCF should also consider extending the duration of the bond portfolios.

With the understanding of how CCF can be expected to perform in different economic and geopolitical environments, we can observe how investors make the mistakes of engaging in recency bias and resulting. In the following analysis, for exposure to CCF, I chose to use PIMCO’s Commodity Real Return Strategy Fund (PCRIX) because it has almost $10 billion in assets under management and more than a 20-year track record (we want to observe the longest data series available), and we want to look at an investable strategy that includes live trading costs as well as fund expenses (indices do neither). We will also consider a simple, traditional 60/40 portfolio that includes two widely used index funds: Vanguard’s 500 Index Fund (VFINX) and Intermediate Treasury Index Fund (VFITX). Using the backtest tool at Portfolio Visualizer, we begin by examining the performance of the three funds over the 13-year period 2008-2020. Over this period VFINX returned 9.7 percent per annum, VFITX returned 3.9 percent per annum and PCRIX returned -4.2 percent per annum. Clearly, PCRIX performed poorly and dramatically underperformed the two index funds.

As an advisor for more than 25 years, experience has taught me that one of the worst mistakes investors make related to judging the performance of risk assets is that they believe three years is a long time, five years is a very long time, and 10 years is an eternity. That belief causes them to be subject to recency bias, hindsight bias and engaging in resulting.

Recency Bias

Patience: A quality apparent among such lower life forms as snails and tortoises but rarely among humans who invest in financial assets. -Jason Zweig, The Devil’s Dictionary

While the 13 years 2008-20 may seem like an eternity to most investors, when it comes to risk assets, 13 years may be nothing more than what economists call “noise”-a random period over which the risks of that strategy happened to show up. If you doubt that, consider that there have been three periods of at least 13 years-1929-43 (15 years), 1966-82 (17 years) and 2000-12 (13 years)-over which the S&P 500 underperformed totally riskless one-month Treasury bills. That’s almost half of the last 93 years! Because they outperformed over the full period by 6.6 percentage points a year, that means they had to outperform by wide margins over the other 48 years. Of course, to earn that 6.6 percent excess return, one had to be invested the entire time (or be able to successfully time markets, which few have been able to do). Hopefully, during those long periods of poor performance, investors didn’t give up on their belief that it was correct to include an allocation to equities in their portfolios.

Yet, when it comes to unconventional (alternative) investments such as commodities, or factor strategies such as value investing and trend following (time-series momentum), investors often abandon strategies after just a few years of underperformance. As Ken Fisher and Meir Statman noted in their 1992 paper “A Behavioral Framework for Time Diversification,” “Three years of losses often turn investors with thirty-year horizons into investors with three-year horizons: they want out.” That’s recency bias at work.

Losing Unconventionally Is Hard

Another issue that undermines discipline and the ability to adhere to a well-thought-out plan is that it is much harder psychologically to underperform unconventionally than it is to underperform conventionally (such as investing in the S&P 500 or a traditional 60/40 portfolio). One reason for that is that misery loves company. Another problem is that even investors who took the time to learn the historical evidence can find that living through hard times is much harder than observing them in backtests. That difficulty helps explain why it’s so hard to be a successful investor.

Having observed the poor performance of CCF over the 13 years 2008-20, investors subject to recency and hindsight biases might wonder why they ever invested in them. However, as Taleb noted, that fails to consider the rationale for investing them in the first place-the quality of the decision-making process. Note that the 2008-20 period was characterized by exactly the type of regimes in which CCF would be expected to perform poorly, as we had inflation of just 1.7 percent (well below the historical average), a positive supply shock (due in part to the fracking revolution), weak economic growth (not a single year of U.S. real GDP growth of at least 2.8 percent) and two negative demand shocks (the Great Recession and the COVID-19 crisis). In other words, you invested in CCF to protect against the risks of negative supply shocks and unexpected high inflation, neither of which occurred, so you believe you made a bad decision. That is like believing you made a bad decision by purchasing earthquake insurance because no earthquakes occurred. As Taleb noted, thinking that way is wrong because it fails to consider the costs of the alternatives. That’s the mistake of resulting.

In my book “Investment Mistakes Even Smart Investors Make and How to Avoid Them,” the resulting mistake is called “confusing before-the-fact strategy with after-the-fact outcome.” The mistake is often caused by hindsight bias-the tendency after an outcome is known to see it as virtually inevitable. As John Stepek, author of “The Sceptical Investor,” advised: “To avoid such mistakes, you must accept that you can neither know the future, nor control it. Thus, the key to investing well is to make good decisions in the face of uncertainty, based on a strong understanding of your goals and a strong understanding of the tools available to help you achieve those goals. A single good decision can lead to a bad outcome. And a single bad decision may lead to a good outcome. But the making of many good decisions, over time, should compound into a better outcome than making a series of bad decisions. Making good decisions is mostly about putting distance between your gut and your investment choices.”

Good Decisions Can Lead to Bad Outcomes

In his 2001 Harvard commencement address, Robert Rubin, former co-chairman of the board at Goldman Sachs and Secretary of the Treasury during the Clinton administration, addressed the issue of resulting. He explained: “Individual decisions can be badly thought through, and yet be successful, or exceedingly well thought through, but be unsuccessful, because the recognized possibility of failure in fact occurs. But over time, more thoughtful decision-making will lead to better results, and more thoughtful decision-making can be encouraged by evaluating decisions on how well they were made rather than on outcome.”

Having reviewed the performance of CCF over the 2008-20 period when they performed so poorly, we now turn to reviewing their performance over the full period February 2002 (the inception of PCRIX) through August 2022. We will also review the performance of the traditional 60/40 portfolio and how a 5 percent allocation to PCRIX could have hypothetically impacted it .

Again using the backtest tool at Portfolio Visualizer, over the period July 2002-August 2022, PCRIX returned 4.6 percent, VFINX returned 9.1 percent, and VFITX returned 3.5 percent.

Now we turn to how the addition of PCRIX to a traditional portfolio would have impacted performance. Portfolio A is the traditional portfolio with an allocation of 60 percent VFINX/40 percent VFITX. Portfolio B introduces a 5 percent allocation to PCRIX, reduces the allocation to VFINX, and retains the 40 percent allocation to VFITX. As we discussed earlier, longer-term bonds mix better with the risks of CCF than do shorter-term bonds. With that in mind, Portfolio C includes the 5 percent allocation to PCRIX, but replaces VFITX with Vanguard’s Long-Term Treasury Index Fund (VUSTX).

Annualized

Return (%)

Standard

Deviation (%)

Sharpe Ratio

Portfolio A

(60% VFINX/40% VFITX)

7.3

8.6

0.73

Portfolio B

(55% VFINX/5% PCRIX/

40% VFITX)

7.2

8.3

0.74

Portfolio C

(55% VFINX/5% PCRIX/

40% VUSTX)

8.0

8.7

0.79

As you can see in hypothetical Portfolio B, despite underperforming VFINX by 4.5 percentage points per annum, replacing 5 percent of the allocation to VFINX and adding a 5 percent allocation to PCRIX resulted in a very similar portfolio performance-slightly lower return, slightly lower volatility and a higher Sharpe ratio. This result is just one example that demonstrates the importance of considering not only the return of a strategy but also its correlation with other portfolio assets and its volatility. The addition of even a small allocation to assets with negative correlation and high volatility can have a positive impact on a portfolio even when its returns are relatively low.

Now we turn to combining the strategy of adding a 5 percent allocation to PCRIX with also increasing duration of the bond allocation by replacing VFITX with VUSTX. As you can see, hypothetical Portfolio C produced a higher return, a slightly higher level of volatility and a superior Sharpe ratio. When we look at the portfolio as a whole-in my opinion the correct way to view things-it would be hard to make the case that it was a mistake, even in hindsight, to add the 5 percent allocation to PCRIX.

We can also look at another example, using a more moderate increase in duration risk. We replace VFITX with the iShares 3-7 Year Treasury Bond ETF (IEI) and replace VUSTX with the iShares 7-10 Year Treasury Bond ETF (IEF). Unfortunately, that limits the time frame available to us to February 2007-August 2022. (Over the period July 2002-January 2007, the period we lose, PCRIX returned 18.6 percent).

Annualized Return (%)

Standard Deviation

(%)

Sharpe Ratio

Portfolio A

(60% VFINX/40% IEI)

7.0

9.0

0.71

Portfolio B (55% VFINX/5% PCRIX/40% IEI)

6.7

8.8

0.69

Portfolio C (55% VFINX/5% PCRIX/40% IEF)

7.1

8.8

0.73

Even though we excluded a period when PCRIX performed very well, we find similar results to those we found in the first example-adding a small allocation to PCRIX in order to provide insurance against negative supply shocks and unexpected inflation-and adding duration produced the highest return and the most efficient portfolio (highest Sharpe ratio).

Accessing CCF

As mentioned earlier, we used PCRIX-expense ratio of 0.76 percent-in our example because of the longer time of the data available. Investors could consider other funds that also provide exposure to CCF. Two of them with significant assets and significantly lower expenses are Dimensional’s Commodity Strategy Institutional (DCMSX), with an expense ratio 0.31 percent and assets under management (AUM) of about $1.7 billion as of October 20, 2022, and Vanguard’s Commodity Strategy Fund (VCMDX), with an expense ratio of just 0.20 percent and AUM of about $2 billion as of October 20, 2022.

Investor Takeaways

Even with the benefit of hindsight, it would be hard to make a case against at least considering including in your portfolio an allocation to commodities, especially for investors concerned about the risks of unexpected inflation and negative supply shocks. Yet, the mistakes caused by recency bias, hindsight bias and engaging in resulting, in addition to failing to consider how an allocation to CCF impacts the risk and return of the entire portfolio, have caused many investors to ignore the potential benefits.

Equities have significant exposure to event risk. Unexpected events like wars, disruption to oil supplies, political instability or even a colder than normal winter, can drive up energy prices, acting like a tax on consumption and negatively impacting the economy and stock prices. Similarly, droughts, floods and crop freezes can all reduce the supply of agricultural products, and strikes and labor unrest can drive up the prices of precious and industrial metals. These various events are also uncorrelated to each other, providing an important diversification benefit if one has invested in a broad commodity index.

It’s worth noting that most shocks to commodities are negatively correlated with financial assets because they tend to suddenly reduce supply rather than increase it. Supply shocks not only tend to lead to inflation (which is negatively correlated with stocks) but also to higher costs of production inputs (putting pressure on profits). Because commodity shocks tend to favor supply disruptions rather than sudden increases in supply, commodities tend to provide positive returns at the same time financial markets are providing negative returns. Thus, the more investors are sensitive to event risk, the more they should consider holding commodities as a hedge against that type of risk. Therefore, while many investors think of commodities as “too risky,” the more risk averse an investor (at least to event risk), the more they should consider including an allocation to commodities. And the more sensitive they are, the greater should be the allocation.

The bottom line is that the case for including commodities as a diversifier of risks, hedging against certain types of risk, still holds. If you are concerned about event risks and unexpected inflation, it is worth considering a small allocation to CCF in your portfolio, along with TIPS. With that said, it is important to recognize that, like other hedging (insurance) assets, CCF can be highly volatile and have the propensity to go through long periods of poor performance followed by shorter periods of strong outperformance.

A good example of another hedging (insurance) asset with similar propensities is gold. Over the 23-year period 1980-2002, gold lost a cumulative 32 percent. That’s even before considering that cumulative inflation was 136 percent over the period (demonstrating that gold is not a good inflation hedge unless your horizon is perhaps a century). Over the next 10 years gold returned a cumulative 381 percent, while inflation increased just 27 percent. Over the period since then, January 2013 through July 2022, gold once again went into a slumber, returning a total of just 5 percent (0.5 percent per annum), underperforming inflation by 25 percent-and inflation spiked in early 2021. In other words, both gold and commodities in general are investments suited only for those with patience and discipline, not those subject to recency bias. In the case of PCRIX, from July 2002-December 2007 it returned 19.9 percent per annum; from 2008-2020 it lost 4.2 percent per annum; and from January 2021-August 2022 it returned 34.4 percent per annum (but only for those investors who stayed disciplined).

Summarizing, CCF did perform poorly over a long period, but that alone should not have caused investors to abandon their strategy because, had they known the economic regime that would exist from 2008-2020, they would have avoided investing in them. That is no different from how we should think about investing in stocks in general; we don’t have any crystal balls that allow us to know what regime will exist. Thus, the only right way to judge performance is based on the quality of the decision, not on the outcome. During the period of poor performance, the risks of CCF happened to show up and their hedging benefits were not needed. But that could not have been known before the fact.

To help you stay disciplined and avoid the consequences of recency bias and hindsight bias, the following suggestion is offered. Whenever you are tempted to abandon your well-thought-out investment plan because of poor recent performance, ask yourself this question: Do the same reasons you purchased the investment (in the case of CCF, it was to hedge the risks of negative supply shocks and unexpected inflation) still exist? If so, then what is the logic of abandoning your strategy? If that’s not sufficient, remember Buffett’s advice to never engage in market timing (his favorite holding period is forever), but if you cannot resist the temptation, then you should buy when others panic and sell.

Postscript

This article is not meant to be a recommendation to invest in commodities. It is meant to educate investors on the proper way to think about risk assets and their roles in a portfolio, and the importance of patience. However, the evidence demonstrates a good case can be made for including an allocation to CCF for those investors concerned about hedging certain risks.

With that said, recent innovations in finance, including the introduction of interval funds, which offer access to investments that don’t permit daily liquidity, have provided investors with options that can also be used to diversify risks and hedge inflation risk. Like commodities, these alternative options all have low to no correlation to stock and bond returns, but they may have higher return expectations because they capture the risk premium associated with them. Alternatives that investors may consider ahead of commodities are AQR’s long/short Style Premia Alternative Fund (QSPRX) for tax-advantaged accounts or its long/short Alternative Risk Premia Fund (QRPRX) for taxable accounts; Stone Ridge’s consumer, small business and student loan fund (LENDX); Cliffwater’s CCLFX (a middle market private lending fund) and their extended credit lending fund (CELFX); and reinsurance funds from Stone Ridge (SRRIX and SHRIX) and Amundi Pioneer (XILSX).

For illustrative purposes only and should not be construed as specific investment, accounting, legal, or tax advice. Certain information is based upon third party data and my become outdated or otherwise superseded without notice. Third party information is deemed to be reliable, but its accuracy and completeness cannot be guaranteed.

The information above includes illustrations of returns of portfolios which are purely hypothetical. Hypothetical performance results (e.g., quantitative back tests) have many inherent limitations, some of which, but not all, are described herein. This information should not be considered as a demonstration of actual performance results or actual trading using client assets and should not be interpreted as such. No representation is being made that the implementation of a certain strategy will or is likely to achieve profits or losses similar to those shown herein. The results may not reflect the impact that material economic and market factors. The results are based on the retroactive application of a back-tested model that was designed with the benefit of hindsight and should not be interpreted as the performance of actual accounts. Past performance is not a guarantee of future results. A client may experience a loss when implementing an investment strategy.

Back-tested data does not represent the impact that material economic and market factors might have on the decision-making process if the advisor were advising an investor. The back-testing of performance differs from actual account performance because an investment strategy may be adjusted at any time and for any reason and can continue to be changed until desired or better performance results are achieved. The back-tested results are based on multiple assumptions including that the portfolio is rebalanced annually and that all dividends are reinvested. In addition, these results do not account for any type of potential tax consequences.

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