|The following summary appeared in the January 2005 issue of the NBER Digest.|
"The economic rationale for these returns is the reward that investors in commodity futures receive for providing price insurance to commodity producers."
Imagine an asset class whose returns are the same as those on the stock market but less volatile, and which are negatively correlated with stock-and-bond returns and positively correlated with inflation. That asset class is an investment in commodity futures. And, despite being a very old asset class, commodity futures are not widely appreciated.
In Facts and Fantasies About Commodity Futures (NBER Working Paper No. 10595), co-authors Gary Gorton and Geert Rouwenhorst show that over a 45-year period a diversified investment in collateralized commodity futures has earned historical returns that are comparable to stocks. That reward, rather than foreseeable trends in commodity prices, is the key to the returns that a futures investor can expect. Individual commodities can be very volatile, but much of this volatility can be avoided by investing in a diversified index of commodities.
Futures contracts are agreements to buy or sell a commodity at a future date, at a price that is agreed upon today. Except for collateral requirements, futures contracts do not require a cash outlay for either buyers or sellers. On average, the buyer of a futures contract is compensated by the seller of futures if the futures price is set below the expected spot price at the time of the expiration of the futures contract. The opposite is true when the futures price is set above the expected future spot price. In 1930, John Maynard Keynes postulated that sellers of futures (hedgers) would compensate the buyers of futures (speculators), a situation he referred to as "normal backwardation." By examining the returns to futures over long periods, Gorton and Rouwenhorst indirectly test this Keynesian prediction.
They construct a dataset of returns on individual commodity futures going back as far as 1959. The dataset combines information about individual commodity futures prices obtained from the Commodity Research Bureau (covering, among other exchanges, the CBOT and CME) and the London Metals Exchange. Investment returns are computed by "rolling" positions in individual futures contracts forward over time. Commodities are combined into an equally weighted index; much of the paper is concerned with the behavior of this index.
Historically, the average return on the equally weighted index of commodity futures has exceeded the return on T-Bills by about 5 percent per annum. This is about the same as the historical risk premium on stocks (the equity premium) over the 1959-2004 period, but the commodity index has slightly lower standard deviation than the S&P 500. The relatively low volatility of the commodity index stems from the fact that the pair-wise correlations between individual commodities are relatively low.
Commodities are also less risky by other standards. First, the distribution of commodity returns is skewed right, whereas equity return distributions are skewed left. In other words, relative to a normal "bell-shape" curve, equities experience proportionally more crashes, whereas the "crashes" in commodities occur most often on the upside, leading to positive returns to investors. Further, Gorton and Rouwenhorst show that commodities have the ability to diversify portfolios of stocks and bonds. The sources of the diversification benefits are the ability of commodities to provide a () hedge against inflation - stocks and bonds are poor hedges by comparison - and to ly offset the cyclical variation in the returns of stocks and bonds.