E5: Commodities in Your Portfolio: How & Why

Should commodities make up a portion of your investment portfolio? If so, what kind of exposure should one add, and by what means should commodities be added to a portfolio, ie Futures, funds, options, metals?

Also, on every episode, we discuss "What's the Most Important Thing" at the moment and help clear up what you might be hearing in the headlines.

We hope you’ve gained some valuable insights or maybe even a fresh perspective on our topic today. We would love to hear from you with your questions or specific topics you would like us to cover. Simply email us your questions or suggestions to info@basepointwealth.com and who knows, your topic might be featured next.

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Transcript

00:05

Welcome to the Point podcast. We have informed intelligent conversations about today's financial topics submitted by viewers like you. These thoughts were originally recorded on October 20th, 2023. Let's go ahead and get started. Here are your hosts, Landis Wiley and Allen Wallace.

00:25

Hello and welcome into today's episode of The Point, sponsored by Basepoint Wealth. I'm your host, Landis Wiley, sitting here as always with Allen Wallace, Chief Investment Officer. Thanks for taking time out of your busy day to join us. If this is your first time tuning in, Allen and I just like to talk about finance, and that's really what The Point is all about, just having a conversation about stuff that's happening out in the world of finance, markets, economy, what have you. So hopefully through the course of our conversation here today, we'll demystify a topic that maybe you are

00:54

hearing about on the news, reading about in the newspaper or online, or talking about at work with your coworkers and friends. The way this works, if you haven't tuned in before, Allen and I have no idea what we're going to talk about. We have a hat full of topics that have been submitted by you, our viewers, and those at work at Basepoint. And we just like to draw it, see what we get to sit here and chat about it. Always exciting. So, before we get into that, we like to kick off each episode with a brief segment called The Most Important Thing.

01:22

The most important thing is exactly what the title says. It's something going on in the world of finance today that's really impactful, maybe impacting you and your pocketbook, maybe impacting how your portfolio works. And so Allen, without further ado, let's hear about the most important thing. The most important thing right now is employment data, one of the Fed's two mandates and a crucial indicator of economic health. The typical march to recession includes an inverted yield curve, a yield normalization, and a souring of the jobs market.

01:51

While this is not always the case, it is what we would expect if a recession were coming. The jobs numbers continue to be reported as strong and unemployment is low, but rising slightly. However, there are several concerning factors at play that warrant attention. Jobs are reported on the Establishment Survey, which is comprised of information from businesses. The Household Survey, as the name suggests, is taken from individuals and it produces unemployment numbers. A couple of key differences are that the Establishment Survey counts part-time work and second jobs as full jobs, while the Household Survey does not.

02:20

Digging into the numbers shows us that these two surveys disagree. There is currently a 9 million job difference between the two. Most of this divergence is due to part-time work, multiple jobs, and seasonal adjustments. Further, the data shows that all new net employment since 2018 has been filled by foreign-born workers, meaning that any drastic change in immigration policy may put an end to the apparent strength in the jobs report and push us closer to a potential recession. Keep your eyes on both the jobs numbers and unemployment numbers and any continued disagreements between the two.

02:49

Today's episode is brought to you by Basepoint Wealth. A question for you to consider, is your present financial strategy working for you? Do you want another viewpoint? It may be time to talk to the experts at Basepoint Wealth. Call 319-826-1898 now for a complimentary financial consultation. Take control of your financial future with Basepoint Wealth.

03:15

Great. Well, thanks for that, Allen. Really appreciate it. And with that, we'll get into the meat of our episode here and figure out what we're going to chit chat about. So let's get our riveting hat here and see what kind of topic we get to discuss.

03:32

All right. Let's see what we got. Today's topic, should commodities make up a portion of my investment portfolio? If so, what kind of exposure should I add? And by what means should I add commodities to my portfolio? For example, futures, fund options, and physical metals. All right. So, commodities. Lots of different ways that we can go with this. When people think of commodities, we're here in Iowa, so a lot of times commodities come down to

04:02

Corn and beans. Corn and beans, hogs, dairy cattle, whatever. On the other hand, you've got the other side of commodities people think about often, which is probably gold and silver, most common ones. Really commodities encompass a whole host of things. You've got oil, you've got coal, you've got almost anything that you can physically touch or store. I think most people when they think of building out an investment portfolio, they probably don't think a lot about holding corn in it.

04:31

So I'm guessing this question really probably deals mostly with things like gold and silver, maybe some oil in there. So certainly those are wide ranging topics. I think maybe one thing that has always fascinated me in the conversation of holding commodities is the how do you do it? To most people, maybe the idea of well,

04:51

how do I hold a gold bar in my IRA? Seems a little difficult. Or how do I buy a barrel of oil? And I think something that we often run into with clients as we look at portfolios is there's lots of marketing out there around, you can buy a fund, you can buy an ETF that says it's a gold strategy or an oil strategy, and maybe it's a levered strategy. And fundamentally, the marketing or the name of those funds may be a little misleading, right?

05:21

They don't always necessarily hold exactly what they say. Let's talk about that a little bit. We typically think of commodity as more along the lines of hedging as opposed to an investment. There's only a single stream of income with the commodity and that's when

05:38

you sell it. So, you buy the commodity and then you sell it. There's no income really generated. And as a matter of fact, there's negative income generated because you have to store it, you have to ensure it, you have to transport it. So you have a negative carry on an asset that

05:53

generates zero income except for the day that you sell it. So, it's not really what I would consider an investment. It's really more of a speculative type operation if you're buying it specifically because you think it's going to go up in price. Our principles state that we don't speculate with client money. Now, with that said, there could be a legitimate purpose for hedging using commodity. The classic example that Reid Dalio has talked about before is when he worked with McDonald's,

06:21

trying to figure out how to make chicken McNuggets because the chicken markets were so volatile. So, he used mathematics to figure out how much feed you need to buy in order to create, turn a chick into a full-grown chicken in order to lock in the price of chicken so that McDonald's could stabilize the menu price well.

06:38

I think that's a legitimate business purpose for commodities. Holding a bunch of corn in your portfolio, probably not a great idea because there's spoilage, there's expenses of storage and insurance and all those things I mentioned earlier. I wouldn't look to fill a grain bin full of corn as part of your investment portfolio. If you're in business, then you might have a legitimate reason for buying and selling commodities, but most of our clients aren't in that category.

07:07

As far as gold and silver are concerned, those are precious metals. Silver has a dual role as a precious metal and an industrial metal. When you're buying those, you're buying those more as a hedge against inflation. You're not trying to do anything short-term, generate income, or have wild price fluctuations that are going to benefit you. You're more worried about deterioration in currency or negative interest rates. Those are the types of things that would cause you to look at precious metals.

07:37

Silver would depend on the gold to silver ratio, which tells you how much silver you can buy for an ounce of gold. That ratio has been sort of at the higher end of historical levels. So, if you go back to Roman times, you'll see that gold is typically traded about 15 times the price of silver. And the reason for that is because there's about 15 times more silver in the ground than gold. Recently that level has been up in the hundreds. So as

08:05

a mean reversion type trade, we're holding both gold and silver because that ratio should move down over time based on the supply of silver in existence. We own those precious metals not as investment opportunities, but as hedges against things that might happen in the currency markets or the interest rate markets.

08:25

Okay. So, when you think of it that way, if maybe commodities in general aren't necessary, an investment under themselves, they're a hedge. So, maybe start with the conversation around the McDonald's chicken nugget piece. Would it be, if you're building on a portfolio and let's say that you own stocks that you have concern about their performance in a certain type of market, right? Use the McDonald's one.

08:53

I own McDonald's, but I'm concerned because I look out there and I see the price of chicken and beef and everything skyrocketing. So, I worry about what that's going to do to the bottom line of my McDonald's holding. Would it be sensible for a person to consider going out and doing some type of hedging on their own? Or would it be more likely true that particularly among your major companies that they're probably already doing some type of hedging within their own operation?

09:20

By owning McDonald's, you're probably hedged to that type of a risk. Yeah. I think the majority of the activity in the commodities markets is from businesses that are conducting transactions in order to stabilize operations. I think that that's a legitimate purpose for the commodities markets. Typically, your average retail investor is sort of just adding to the volatility. We really have no

09:48

reliable methodology for determining whether commodities are going to go up or down in a short-term period of time. The bias is up over time because of inflation, but keep in mind that usually you're not buying a big pile of corn. You're buying futures contracts on corn. Because of the way that those contracts are priced and because they have an expiration date, you have to roll them over periodically and you end up with what's called negative roll yield.

10:16

So if you were to perpetually hold futures of commodities over time, you would eventually erode away all of your principal. The option of buying a bunch of corn and sticking in a silo, probably not that great because there is spoilage over time. You get mice, the bin burns down, those kinds of things. Typically, the average investor is going to get access through some sort of

10:40

fund, some sort of CTA or some sort of hedge fund that is buying and selling futures contracts. The problem with that is almost all those strategies are momentum-based, which means they try to find things that are appreciating in price and buy those. They try to find things that are dropping in price and sell those. Really, you just get this trading that's going on, trying to take advantage of price moves. That's antithetical to our entire investment process. Just because there's inflation doesn't mean that 

11:07

your commodities fund is going to go up in value if they're making bad decisions on what they're buying long and what they're selling short. So, let me jump in there for a second because I think this is an area where the average investor out there maybe gets crossed up a little bit in some of the marketing that our industry does around funds and the title of the fund and the title of the ETF. You mentioned that if you could go out and buy a fund of corn commodity, let's say

11:36

that there's probably very little, if any actual corn. I'd say there's none. It's probably a fair statement. But take corn and let's replace it with oil. Let's talk about the oil ETFs because there are lots of those. One of the questions I can remember hearing a lot of was, and it's probably been seven, eight, nine years ago,

11:59

there was considerable volatility in the energy market and in the oil markets. And I recall some friends buying oil ETFs, and they were buying two and three times levered oil ETFs. And they seem to be perpetually confused about why the behavior of these ETFs wasn't following what they were seeing with the oil

12:29

markets. Well sure because they're looking at the spot price, but what they really own is a you know derivative of the future price right so as future expectations change even if the spot price is a certain level, it doesn't necessarily mean that the futures prices are going to follow that and then you introduce leverage. And a cost structure and you end up with results that can diverge significantly from the from the current spot price which means the price you can go out and buy it for today in the open market.

12:56

So, I think this brings up maybe one of the challenges that investors run into out there when they're maybe wanting to get into the commodities markets within a portfolio, either as a hedge or because they view it as the potential of, oh, oil is cheap, so I'm going to buy cheap oil, right? And then ride the wave on the other side when in fact, what you're saying is most

13:23

ETF and fund vehicles aren't necessarily, you're not purchasing oil at today's price. You're purchasing primarily a basket of futures contracts that are anticipating where oil is going to go. And so even though oil today might be low, the futures contracts in there may already be priced for that higher price point. Sure. And even worse than that is there's no guarantee that there is an adequate supply to even cover all the futures contracts which are outstanding.

13:53

The oil and other commodities markets that you can have significantly more futures contracts outstanding. Right. So, I've seen estimates there are a hundred times more paper silver out there than there is physical silver.

14:04

So, if even 1% of all futures contracts demanded delivery, you would immediately have failure to deliver on the majority of those contracts. So, it's dangerous to have these levered securities that dominate the entire market and sometimes are orders of magnitude greater than the actual physical markets.

14:27

So, you bring up, for example, the silver market. So, let's talk about that a little bit, because obviously Basepoint uses gold and silver within its alternative asset sleeve. And we've just got done saying here, well, it's really difficult to go buy funds that hold the actual commodity. They're typically paper-based. So what's Basepoint doing? As you're looking at it as Chief Investment Officer and wanting to add in a hedge, whether it's inflation or whatever it is.

14:57

What kinds of things are you looking for? What types of things should an investor be paying attention to and looking for if they do want to bring some type of commodity or precious metal exposure in? I spent a lot of time on this because there wasn't really

15:13

a good way to do this 10 years ago. I looked at ETFs, but they were all futures-based, which means that in a failure to deliver sort of scenario, when people started demanding delivery and there wasn't a physical commodity out there, they would basically be worthless. You're buying these for depreciations in currencies or sort of big things that happen. I would hesitate to buy precious metals for like a Mad Max type scenario, right? No one's going to sell you their last sandwich.

15:40

if we're really in one of those types of scenarios. I don't think it's doomsday protections, but it really would help against loss of reserve currency status or depreciation of the dollar, that type of thing. What we did is we found a fund that actually holds physical bullion. They're Canadian, so they're storages that the Royal Canadian mint.

16:01

Every dollar that's in the fund is physically represented by actual bullion held at a mint somewhere. We have the opportunity to demand delivery. We wouldn't be able to do that on a client-by-client basis, but the entire firm would be able to work that out. I hope we never have to use that alternative, but it is possible. We can avoid that

16:27

future scenario where there's not enough physical commodity to deliver on your contracts. Right. And so, I guess maybe my follow on question to that or my thought is, okay, so using a fund that holds physical bullion, why not just hold the physical bullion? Yeah, because of the storage concerns and the transportation concerns, right? So this means at a mint, we can buy physical...

16:52

gold and silver and I think, palladium and platinum via our custodian, but the costs are prohibitive as far as how much it costs for them to store it for us. So, we're getting a better deal on the fund as far as the cost is concerned. And again, that's domestic, whereas the funds are outside of the United States. If we go back to the 1930s, there was a period of time where FDR actually made it illegal for an individual to own gold

17:17

in their possession. So having it outside the borders, I think, gives us a little bit more protection in that front. And obviously, on any kind of a scale, that's one of the challenges with any commodity is fundamentally storage, right? I mean, gold is, if you own enough of it, or you own it in mass, number one, it's heavy. Number two, you've got to find a place to put it. Number three, you've got to figure out a way to secure it. Because in that Mad Max scenario,

17:44

people are probably going to want to come get your stuff. Well, we have a vault here, but the vault is only as strong as the person with the combination. So,  it's probably better off in the hands of professionals. Right, absolutely. And same thing with oil or anything else. There was a period of time there in 2020. I can remember oil getting down to the point where it was, you know,

18:04

trading at a negative number, which was kind of crazy. Yeah, that was just for a couple of days. I think it was the North Dakota Sour actually, they were paying you to take it from them. Now, if only we had a whole bunch of storage. Yeah, that would be great, right? Just bring the truck up and dump it in there. So interesting topic, because this is certainly something, and with periods of market volatility like we've had for the last two years, I think you start to hear a lot more about owning things like gold and silver, or owning commodities.

18:34

We've had a lot of volatility in energy markets. There's been a lot of interest in owning oil and participating in that. So, it's an interesting topic, very timely. Fundamentally, what would our message be to an investor when it comes to

18:50

commodities and precious metals? Well, I think it's what we tell everyone, which is know what you own, first and foremost. Don't just go out and buy an ETF because it has Nickel in the name and you think that Nickel is going to go up. That's probably futures-based. They're probably dealing with monthly contracts. You could end up losing a significant amount of money over a period of months if they have some sort of negative rule yield and

19:12

ETFs start to deteriorate in value. You have to know exactly what it is that you're getting. You also have the opportunity to buy companies that deal in those commodities. For instance, we own Freeport, which is a big producer of copper. We own oil companies because we felt like the pricing of the companies gave us operating leverage for the price of oil to go up. We didn't have a good solution for buying oil directly.

19:41

EFT’s are mostly futures based and so we didn't feel like there was enough safety in just going out and buying oil funds that were specifically supposed to be tied to the price of oil. If you read the prospectus of a lot of these commodities funds, it tells you right in there that they're not meant to be held for more than a couple days. And in some cases, only for a single day. So, if you feel like the price of oil is going to- Come on, Allen, everybody reads the prospectus. Well, sure. Well, that's what you pay us for, right? But buyer beware.

20:10

I mean, these securities are not meant to be held for more than a couple of days. So there's no way to profit from a long-term move in commodities by purchasing an ETF that's levered to some sort of specific commodity. And that's a fascinating point because most people have been conditioned into, if not a straight buy and hold strategy, but this idea that you should buy an investment with the idea that you would hold it for a long period of time.

20:40

When you start dealing with these commodities funds or ETFs, you're saying that's basically completely the opposite of what you should do. Well, it goes back to the original first statement I made about commodities is that they're not investments.

20:53

You know, there are speculative operations where they could be used for a hedge. So in order for it to be an effective hedge, you have to have some sort of time frame, right? I mean, you know that you need to make a certain number of chicken nuggets before X date, and so you can utilize futures contracts in order to do that. But as far as just saying, I think there's going to be inflation, so I'm going to buy a portfolio of commodities, I don't think that's a viable strategy for most people.

21:14

The commodities funds you get are typically going to be trading-based, and they're going to be trying to take advantage of price dislocations. The issue with that is you can have perfect information, and things can still go against you. And so, I just think there's a lot of luck involved in commodities trading. Now, there are some people out there who are really good at it. I heard a legend about a commodities trader once who had all the data lined up that the price of coffee was going to go through the roof. And so, he

21:43

went into coffee, he went in on leverage, and this was going to make his career. But then suddenly some sort of wind that only happens in Africa and blows a huge dust storm across the entire continent occurred that year unexpectedly and wiped out the coffee crop and this guy basically lost everything that he had and owed more money when it was over with. So we have to be really careful about dealing with things on leverage, dealing with things in derivatives contracts because even if we have all the information lined up, there are certain things that

22:13

happen that are unexpected, the known unknowns, to use Rumsfeld's language, can completely wipe us out. So we try to stick to the things that we have some sort of predictive mechanism to determine that this is a good investment over a long period of time, not something that we expect to be volatile in the short term. The definition of volatility means we don't know whether it's going to go up or down. Right. Well, I think that's kind of a great point maybe to draw us up to a close. So I think the message on this topic to anybody considering or interested in adding in commodity exposure in a portfolio is

22:42

rule number one, know what you own. And rule number two, know why you own it. And there's certainly maybe more than meets the eye when it comes to commodity precious metal discussion. Absolutely. So great points. With that, we'll kind of draw this episode to a close. Again, hope this has been informative to you all out there. Thanks again for taking time out of your day to join us. If you have any questions or thoughts that you'd like to maybe hear Allen and I sit here and banter on about.

23:09

You're welcome to go to our website, basepointwealth.com, or send us an email, info@ basepointwealth.com. And who knows, maybe one of these days your topic will be the one we pull out of our trusty hat over here. So thanks again for tuning in and until next time, take care.

23:28

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23:58

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