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Are Commodity Futures a Good Hedge?

Question: I’ve been holding PCRDX since 2006 in a tax-sheltered account. How have I done? What are your current thoughts on commodities?

Answer: PCRDX is the PIMCO Commodity Real Return Strategy Fund, which uses Treasury Inflation Protected Securities (TIPS) as collateral for a 100% long investment in a basket of commodity futures. Depending on when in 2006 you made your investment, at this point you’re either up very little or down very little on the fund itself. (Although its per-share trading price has dropped considerably, massive cash distributions in profitable years bring the total return back up to around the breakeven point.) Of course, if you give me 10 years instead of seven, PCRDX is up around 60%, but that’s not when you started.

I presume you invested in it for the reasons I was doing so then, as a hedge to protect yourself in bad stock market years. In the past half century, there have only been four years when both U.S. stocks and commodity futures have dropped. Unfortunately, 2008 was one of those four years: commodity futures proved useless as a hedge in the last bear market. The reason is that a long-only commodity-futures fund is intended as a hedge against inflation and what we had in 2008, for the first time since the 1930s, was a massive deflation scare, which is very bad for commodity futures. One of the things that appeals to me about PCRDX hurt it in the late 2008 crash: using TIPS as collateral supercharges the inflation protection (most commodity futures funds use T-bills) but added to the hurt during the deflation.

I’ve long minimized the importance of protecting against deflation, feeling that a decline in the cost of living is its own reward, which compensates for declines in investment values. After all, the price of a gallon of gas dropped from $4.11 in June 2008 to $1.61 in December. My focus with clients is to minimize unnecessary debt, since that is the one thing that doesn’t decline when prices go down. None of my clients enjoyed the 2007-2009 bear market, but most didn’t even have mortgages, let alone unsecured debt, and they were able to patiently wait for the next bull market to undo the portfolio damage.

No hedge works all the time. I still consider commodity futures to be a reasonable hedge against the most common cause of stock bear markets, inflation, and it is certainly acceptable to stick with PCRDX or another broadly diversified long-only commodity-futures fund as a hedge. If you want to protect against deflation as well, you should still look first to pay off all your debts, including your home mortgage. If you’re debt-free and want to include Treasuries as a deflation hedge to go along with commodity futures as an inflation hedge, be my guest. Or you could take a look at managed futures funds, which try to protect against both inflation and deflation at the price of doing poorly when prices are stable.

But my current thinking is that most do-it-yourself investors should consider keeping the next two years of spending money in cash equivalents and otherwise commit to a globally diversified equity portfolio. Accept the periodic bear markets as the price of the long-term rewards and keep life as simple as possible.