Posted on February 27, 2009 by Ben Connard 

We have been searching for an alternative investment in order to add diversity to our portfolios currently balanced between common stocks, bonds and cash. Ideally this investment would have a low correlation with stocks and would be able to hold its value in difficult economic conditions.

We’ve been interested in commodities for a while, but avoided them the last few years because of the commodities bubble. Remember when oil was $150 a barrel? But times have changed, and like equities, commodities have fallen drastically over the last 9 months.

Barclays Bank offers exchange traded notes (ETN) which are a good way to invest in commodities without buying futures. The notes are debt instruments which expire in about 30 years and are structured to offer returns similar to futures. For example, there is an ETN that mimics investing in West Texas Intermediate crude oil futures. Barclays offers two commodity index notes, 7 sector notes and 12 single commodity notes.

Based on correlations, several sectors commodity ETNs looked appealing. However, although some correlations are low, when things go south, the correlation increase, i.e. when the equity markets fell this year, the commodities came down as well. Stocks fall when product sales fall and their cash flows decrease. Commodities fall when demand dries up—in other words, when companies aren’t buying the inputs needed to make their product.

In addition, long-term returns aren’t that appealing, regardless of the correlation. Of the seven sectors (agriculture, energy, grains, industrial metals, livestock, precious metals and softs), only energy, industrial metals and precious metals had a positive return from 1996 – 2008. Diversifying a portfolio with an asset class that is losing value doesn’t make sense.

Why would the long term trends be negative on so many commodity sectors? Commodities are commodities, meaning they can easily be produced and are not easily differentiated.When the supply of wheat falls, the price spikes, but when more wheat is planted the next year the price falls.

There are exceptions, the most obvious being energy (specifically oil) and precious metals.We can’t simply produce more oil and more gold. This explains the long term positive trend in the energy and precious metal sectors. Industrial metals most likely had a positive return over the given period because heavy construction meant high demand. We are not bullish on construction over the next few years.

Are oil and precious metals worth investing? We don’t want to add oil to our portfolios because we already have an overweight in energy companies, minimizing the diversification benefit.

This leaves precious metals, specifically, gold, platinum or silver. We are not interested in platinum because its two main uses are jewelry and auto emissions devices. We do not anticipate jewelry or cars sales being high of the next few years.

We’re left with silver or gold. Silver has historically returned less than gold and is essentially a poor man’s gold. So is gold the answer? Gold is beautiful and rare. But we can’t eat, wear or build with gold. We’re not going back to the gold standard, which we abandoned in 1971 when President Nixon eliminated the fixed price of gold. Historically South Africa is the largest producer of gold and recently China has led production. The U.S. is not going to give dilute its financial power by going back to the gold standard.

In the end, gold prices are based on the perception that people will always value it as a source of wealth. This is not a given—and we are not going to invest based on the perception of value.

In conclusion, the two asset classes that provide the best diversification to common stocks are high-quality bonds and cash.  The real value of these instruments increases during deflationary periods as we are now experiencing.  And unlike commodities, cash and bonds also provide current income through interest payments.