Imagine Investing in Commodities From 2004-2008, And Losing Money

In 2006, Gary Gorton and K Geert Rouwenhorst published an influential paper.

The two academics examined 45 years of performance of commodities and found they “work well when they are needed most”: when stock market returns are disappointing.

Professors Gary Gorton, left, and Geert Rouwenhorst highlighted commodities’ diversification benefits.

The paper’s view was embraced en masse by institutional investors and helped to transform commodities from a niche investment into a proper standalone asset class.

But the diversification benefits of commodities have become increasingly tenuous as prices in the years following the report’s publication moved in tandem with other major asset classes, including shares and bonds.

As stock markets plummeted worldwide in 2008, commodities fared just as badly. And last year both bottomed in March, challenging the notion that they respond to different phases of the cycle.

These correlations have proven nasty for investors, such as pension funds, that piled into commodities as a way to broaden portfolios and spread risk. . . .

Their paper, “Facts and Fantasies about Commodity Futures,” was commissioned while they were consultants to AIG Financial Products, the insurance company subsidiary better known for its fateful push into credit default swaps. . . .

“Undeniably, Rouwenhorst’s and Gorton’s paper had a tremendous impact on commodities as an asset class,” says Christiaen van Lanschot, who runs commodity hedge fund VOC Capital Management. . . .

(Source: “Academics stand by theory of correlativity,” Gregory Meyer, Financial Times, February 9 2010)

Yale University professor K. Geert Rouwenhorst, one of the “fathers” of broad-based commodity investing, has co-founded a new firm and is launching a new generation of commodity indexes.

Rouwenhorst is best known for his 2004 paper with Gary Gorton, “Facts and Fantasies about Commodity Futures,” which kicked off the surge of commodity investing seen in the past five years.

His new firm, SummerHaven Index Management, in December launched the SummerHaven Dynamic Commodity Index. The index is designed to avert the more disastrous effects of contango and other pitfalls of passive commodities investment strategies. SummerHaven described it as “the first long-only active benchmark for commodity investors.”

(Source: “‘Father’ Of Commodity Investing Launches New Index,” Journal of Indexes, March / April 2010.)

Okay, so let’s get this straight. AIG (AIG) paid these two professors to do this research which basically found that commodities were good investments – shocker! (AIG also reportedly paid Gorton $1 million to develop the risk models for CDS – how well did that work out?) This allowed Goldman Sachs (GS) and AIG to go out and hook a large number of pension funds and other dumb money investors into commodity indices promising “equity-like returns” and “low correlation with stocks.”

Now it turns out that once investors flocked into commodity indices that two things happened: (1) They flipped the markets into a state of persistent contango so that instead of the roll yield providing a 4-5% lift to returns (making them equity-like) it is instead causing an 11-12% drag on returns (making them terrible) and (2) The correlation between the S&P 500 and the S&P-GSCI index has risen to as high as 80% so that they provide no diversification benefit whatsoever.

Anybody that invested in the S&P-GSCI TR Index from 2004-2008 is losing money as of today.

Can you imagine investing in commodities indices in 2004 and losing money despite the greatest bull market we’ve ever seen in commodities?

Did anyone do their homework on Gorton and Rouwenhorst to find out that they were high paid AIG consultants when they wrote their paper?

Does anybody think now that they’ve abandoned the passive approach in favor of the dynamic approach that it will work any better this time around?