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Andrew Carnegie

Sunday, August 11, 2013

Why You Still Shouldn't Take This Famous Bet

Simon Mayo looking like Colin Murray
Simon Mayo looking like Colin Murray (Photo credit: markhillary)
By Investment U

Chicago, Aug.12, trading stocks .- As raw materials prices soared between 1998 and 2008, many analysts argued that we were in the midst of a commodities "supercycle," and that demand from fast-growing emerging markets - particularly China - would continue to drive prices up for years and years.

Like so many grand macroeconomic and geopolitical theories, however, this one fizzled. In 2008, for example, the DJ-UBS Commodity Index plunged 37%. And prices remain under pressure. The index is down 14% this year, while stocks are turning in a banner performance.

But with raw materials cheaper, is this the time to buy?
Probably not. And if you know about free-market economist Julian Simon's famous bet, you'll understand why...

In 1980, Simon entered into a wager with Paul Ehrlich, a famously gloomy "futurist" and author of The Population Bomb, a book that argued that world population growth was outstripping the fixed supply of resources and would soon cause a global economic catastrophe.

Simon was skeptical and bet Ehrlich $1,000 that any five raw materials he selected would be lower 10 years later. Ehrlich agreed and chose five metals he expected to undergo large price increases: chromium, copper, tin, nickel and tungsten.

Between 1980 and 1990, the world population grew by 800 million - the biggest increase in history. Yet each of Ehrlich's selected metals dropped. (In the case of tin, by more than 50%.) Thanks to technology and substitution, commodity prices tend to decline from high levels and, in fact, have done nothing more than track inflation over the long haul.

But low long-term returns are only one reason to avoid or minimize commodity investments. Another is that they don't produce any income. Without dividends or interest payments, you're counting entirely on price appreciation - and history shows that is minimal over the long haul.

Another hurdle is high expenses. Most commodity mutual funds and ETFs don't actually own the soybeans, natural gas or metals they track. Instead, they own contracts that give them the right to buy those commodities at a set time in the future.

As the contracts mature, they "roll" them into later months. But this is expensive, and many funds that invest in commodities have expenses 15 to 20 times higher than the typical .05% of stock and bond ETFs.

If you own just a plain-vanilla S&P 500 index fund, 14% of that money is invested in basic materials and energy companies. So the chances are that you already have low-risk exposure to world commodity markets.

However, I should point out one part of the commodity sector that appears poised for exceptional growth: oil and gas pipeline companies.

These companies, called master limited partnerships, will benefit as booming energy production meets rising demand in the U.S. Aside from being insulated from the ups and downs in energy prices, these vehicles also offer tax benefits. (That's one of the reasons we own Plains All American Pipelines - up more than 70% - in our Oxford Trading Portfolio.)

In short, Julian Simon was right. Direct commodity bets are volatile, expensive and tend to be low-returning over the long haul. The Oxford Club suggests you keep them at 5% or less of your portfolio.

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