Investing in Commodities

A friend of mine asked me today “Should I invest in Gold“? We had a long conversation and I think the following parts of the discussion will be useful to the readers:

My view: Gold will not make money over the long term. I always say ‘People with a long term view should buy S&P 500 and forget about it’. I cannot say the same about Gold. In my opinion, Gold will never deliver above average market returns.

The immediate question I am often asked is – then why do people invest in Gold? The main reason is ‘People are hedging their bets’. They believe Gold prices rise when stock prices fall.

Let us expand our discussion to talk about Commodities (Gold is a commodity. Other examples of commodities include Coffee, Copper, Silver, Aluminum).

The conceptual difference between Corporations and Commodities – if you own shares of Microsoft, you own (partially) a corporation where software developers are working day and night to create value; while if you own Aluminum, then you just own a commodity and it’s price can increase due to enhanced demand, for example an increase in car production will lead to increased Aluminum prices. Because commodities do not create value by themselves, they are non-income producing assets, and therefore do not pay dividends.

The second reason why I do not like Commodities as a long term investment is the expense ratio. A good expense ratio for a basket of Commodities ETF is 0.55% (Symbol UCI). In contrast, a good expense ratio for a S&P 500 ETF is 0.05% (Symbol VOO).

Just so you know the difference this can make – $100,000 invested for 25 years earning 8% per year becomes  $677,000 with 0.05% expense and $603,000 with 0.55% expense. So, you make $74,000 more with the lower expense ratio. In percentage terms, the lower expense ratio returned you 12% more profit.

One thing I have to admit that is going in favor of Commodities today – they seem to be a bargain. They have witnessed significantly reduction in prices over the last several months. For instance, UCI has fallen about 27% YTD (10/21/2015).

To summarize, following are the Pros and Cons of Investing in Commodities:

Pros – Hedge expectations, Trading at a bargain

Cons – High expense ratio, No dividend appreciation

If you decide to invest in Gold, I like GLD.

If you decide to invest in a basked of Commodities, I like UCI and DBC.

Disclaimer: I personally hold long positions in GLD, DBC, UCI, as well as VOO. GLD, DBC, and UCI together account for less than 1% of my portfolio while VOO (and the like) account for about 20%.

One thought on “Investing in Commodities

  1. I generally agree, commodities, especially gold, are rarely as solid a way to go as good stocks because they aren’t productive. Gold is especially bad because if you want to beat the market on a consistent basis there are some key rules it helps to follow and one is “buy for less than they are worth with a margin of safety”. The problem is how do you value gold? It’s a speculative market not one based on utilization.

    That being said there are three ways to beat the market:

    1. Picking better companies

    2. Picking better timing

    3. Using better asset allocation

    The later is the easiest for the average person. Ray Dalio is the master of asset allocation and he argues the average person should have approx 7.5% of their portfolio in gold and 7.5% in other commodities with the rest heavily weighted on bonds and stocks (actually more bonds than stocks by a factor of about 2) and rebalanced annually. Turns out this actually works pretty well so there is a place for it.

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