Talk Your Book: How to Invest in Commodities

0:00Today's Animal Spirits Talk Your Book is brought to you by Harbor Capital. Go to harborcapital.com to learn more about HGER, their Harbor Commodity All-Weather Strategy ETF. That's harborcapital.com to learn more. Welcome to Animal Spirits, a show about markets, life, and investing. Join Michael Batnick and Ben Carlson as they talk about what they're reading, writing, and watching. All opinions expressed by Michael and Ben are solely their own opinion and do not reflect the opinion of Ritholtz Wealth Management. This podcast is for informational purposes only and should not be relied upon for any investment decisions.

0:36Clients of Ritholtz Wealth Management may maintain positions in the securities discussed in this podcast.

0:45Welcome to Animal Spirits with Michael and Ben. Is the dollar bull market over, Ben? Sure seems like it. It's definitely taking a punch on the chin, correct? A punch on the chin. That doesn't sound right. That doesn't sound right. Taking it on the chin. Taking it on the chin. Well, one of the things that benefits with weakening dollar are commodities. And don't look now, Ben, or you can if you want. Gold has been one of the best performing assets over the last year. Over the last couple of years, it's doing well. And the technician in me says it looks like it's going higher. It is going higher.

1:23What are you talking about? Not a prediction. It's going higher. It's up today. Commodity does move higher. I guess people are luring about inflation again. No, it's interesting, though. I was talking with Jan Van Eck about this yesterday. Investors are still apathetic about commodities. They're not seeing a whole lot of investor demand if you look across the industry, which tells me that it's early, and these things tend to run for years at a time. Don't you think it's because that we've been in this essentially sideways market for commodities prices for the big ones, right? Like oil and such that probably that, yeah, investors are right or wrongly just assuming that this is going to continue.

2:07Well, one of the things about commodity products, which we speak about on today's show, is the weighting. Like the Bloomberg Commodity Index, how much of it is energy? Right. And that's what a lot of people think that the benchmark, it's kind of like bonds. Like the S &P 500 is hard to beat, but the bond index, if you just take on some more credit or duration, it's not that hard to beat. But people have problems with the commodity index as well just because of the way – like how do you choose the importance of these commodities? And they did it, what, 35 years ago or whatever when it started. And a lot of people think that there's a better way to do it.

2:43Because it was for suppliers and hedgers. Right. Like it wasn't meant as an investable index. Right. So on today's show, we talked to Don Castara, who's a CIO at Quantix Commodities, and they work with Harbor Capital. So we have Christoph Gleishon again. We've had him on a number of times to talk about their index and then the ETF they created off that index, which they think has a better waiting scheme for more of a long-term buy and hold commodities play. So their ETF is called HGER is the ticker, Harbor Commodity All Weather Strategy. We talk all about how they put it together, how they change the different weights and such.

3:19So here's our talk with Don and Christoph.

3:25All right, guys, welcome to the show. Great to be here. So how is it? Let's start here. How is it that the Bloomberg Commodity Index is still well below its all-time highs, and you guys are beating the pants off it? What is the story with the index that we're going to be talking about today? It really comes down to a difference in weighting methodology. There's a fairly finite collection of commodities that are liquid enough to be considered for indices. Basically, any commodity index will have pretty much the same components to it. But by putting those components together in different weights and arguably a better construction that is more suited to the investor, you can have dramatically different returns.

4:11Okay. What is the way that these indices... I'm still having trouble with indices or indexes. How have they been done in the past and what did you guys do to sort of change the way that they are done? Well, the two most common benchmarks for commodity indices originally was the S &P GSEI. Now more commonly, I think the Bloomberg Commodity Index has become the more common benchmark for commodities. Both of those sort of share a similar history in terms of their construction. They were created primarily to generate offsetting flows for banks, commodity desks, and their producer book hedging. It was pretty much one-sided risk at the desk at those times, which was basically hedging the exposure of commodity producers with no offsetting buyers.

5:00So they created these indices to try to get that offsetting flow, to try to cater them to the individuals of the world that actually had the commodity exposure on the other side. And as such, their weights were basically just world production weighting because they were trying to offset the producer hedging that they had. They weren't specifically they didn't specifically have in mind the investor that may actually want to buy the other side. And that's the biggest difference that we consider in our construction is like, well, what if we approach it from the other side? What if we said, what does the investor want to get out of an allocation to commodities?

5:35In most cases, that's some diversification from a 60-40 portfolio in a way that is going to be effective in hedging inflation. And approaching it from that perspective results in a slightly different commodity weighting to your basket. Is that because back then it wasn't really an investable asset class or it wasn't thought about the same way? Because that has to be part of it too, right? The creation of the B-Com and the GSCI was designed to make it an investable asset class. I mean, obviously, you've got to get your exposure. Most investors are going to want to get their exposure from derivatives, not from actually owning cattle in their backyard.

6:14So in order to do that, they needed to buy futures. And then with futures, you have to have a rolling mechanism so that you don't go into delivery. So a lot of that early work was done to create something that could be investable for people who didn't want physical exposure to commodities but have price exposure to the asset class. But the weightings, like I said, they were mostly driven to say, well, what gives us the offsetting flow to what these producers are selling? And we'll just create that because that's good for our books. May not be as good for the investor. And that got, you know, if I can just sort of jump in, that's what really got my attention and our attention.

6:53So just to back up quickly, at Harbor Capital, we work with specialized boutique managers that we think can deliver strong returns. In this case, we're talking about commodities. And it was that insight that these well-known commodity indices, or it's BCom, GSCI, that we kind of take for granted, were designed for commodities producers rather than commodities investors. and if you look at the returns that commodities have put up for investors it's they're pretty awful um over the long run and you know they have fits and starts where they work and then they don't but if you look over the long-term case the long-term sorry to try and make a strategic case for commodities based on the existing options that existed it's pretty hard to you have to torture any kind of optimization or mathematical model.

7:46And what was interesting here is actually commodities haven't been the problem. It's been the solutions that have been designed to capture the available returns. And so just kind of like rethinking the asset class from first principles, you know, as Don sort of started to explain, we thought we could create a really sort of neat, innovative idea that would allow investors to have a strategic allocation to the asset class. So, Don, when did you have this insight and what did you do to make sure that investors had a better outcome than with the options that are available before you launched? Well, the key thing in terms of an insight was finding an investor that was willing and basically told us that they were willing to deviate from the existing benchmarks.

8:36Part of Part of the other challenge that we face with commodity investing is a lot of investors are in their investment committees are pretty conservative and aren't willing to deviate from an existing benchmark, even if its performance is pretty bad and its construction, potentially even worse. When we first started Quantix, there was an investor out there that said, hey, we recognize the shortcoming of the existing benchmarks. We think commodities can be an effective tool in hedging and dense inflation. Coming out of the pandemic, we really think we are going to be in that environment. And we believe in your skill set to develop something that can be very effective in that.

9:11We're not going to be constrained by tracking error to a benchmark. Can you come up with a framework for something that exists to us? And that's really where this was born, this idea of like, OK, we're being mandated to create an index that's built for an investor, for an investor objective. And that's really what was basically the genesis of where the Quantix Commodity Index came from. So that was late 2021. And then we launched the ETF, the tickers, HEDGER, H-G-E-R. And we launched that on February 9th of 2022, when inflation was getting really, really ugly. and so the ETF is about three and a half years old now and about 600 million of assets.

10:00Pretty good timing on the launch, huh? Yeah. I wish we could have been around a little earlier so that people could have bought it when they needed it. So what is the, I mean, to my mind, oil seems to be like the biggest one, but what are the biggest differences here? What are you over or underweighting versus some of these other benchmarks? So, yeah, we're basically picking from the same commodity universe. I mean, BCom has 23, 24 now commodities in it, and our basket contains basically the same commodities. It's just a different weighting. And the construction mechanism, the key differences in construction mechanism come down to a couple key points.

10:37One, we, as I keep emphasizing, we consider what the investment objective is in terms of what the buyers want to get out of this. So we do a quality score weighting across these different commodity components. And a key feature of that quality score is inflation pass-through sensitivity. The commodities that are in the B-com basket represent a wide range of refinement. You could have something like cotton, which is basically pure cotton just as it comes off the bale, a long way from anything that you would actually use in terms of how that cotton, even the price of a T-shirt, which is the most basic implementation of cotton.

11:18It's only 5 % of the price of that shirt is the cotton, where another commodity that's in the B-Com index, Arbob Gasoline, is what we trade on. What is primarily traded in the component of the B-Com index in gasoline is the same stuff that you put in your tank. So if that goes up in price, the consumer is going to feel it right away. And we consider those type of things in terms of inflation sensitivity, in terms of weighing the basket. We also consider roll yield because, as I mentioned, you're not owning the physical commodity as an investor. You're owning a derivative, which are these futures contracts that need to be rolled from one contract to the next.

11:55And the process of doing that, if there's a contango in the curve, i.e. the futures curve is predicting it to get more expensive, the investor doesn't get those gains. They pay that on a roll away in a cost of carry. So if we wanted to create an index that is a strategic long-term allocation, we need to be sensitive to roll yield and not cost of carry. And different commodities have different characteristics in that regard. And that factors very heavily into the weighting analysis as well. What it tends to result in is being more overweight, refined products, the things that you actually use more than crude oil.

12:34So we own more heating oil, distillate in Arbob gasoline, relatively lower crude oil, because again, that's further away from the actual cost an investor uses, and more overweight gold relative to the rest of the basket. And reasons for that are a little bit different in that we envision this as being something that's durable and appropriate for a long-term strategic investing. and there's not every environment where commodities are so tight that inflation is likely to be caused by scarcity, like we're running out of commodities. There are periods where there's ample supply and holding and rolling those futures contracts when there's ample supply, it could become costly over the long term.

13:19In those environments, you're more likely to get inflation from debasement, where there may be a flood of dollars trying to stimulate demand to try to correct this oversupply situation, which would likely weaken dollars. A rising tide raises all ships. You want real assets in that environment. Gold is really the only commodity that makes a lot of sense as a store of assets. Another key element of our design is dynamically re-weighting between consumable commodities and storable commodities, basically gold in terms of a safe asset. So for a commodities like novice, like me, right, I'm not a commodities expert like Don is.

13:59If I'm holding commodities in a portfolio, presumably I want to hold commodities and I want them to work if there's inflation to protect, you know, my 60-40. So they have a filter and they overweight commodities that do well in inflationary environments. Number two is sometimes holding commodities can be really, really expensive, or sometimes it can be really, really cheap, depending on whether they're in backwardation or contango. And so to skew your commodities exposure towards things that you're getting paid to own rather than paying to hold makes a lot of sense. And then the last thing is commodity, the inflationary environments that we face can be different.

14:40And so different commodities behave in different ways depending on the type of inflation or environment that you're in. And the big differentiator with Hedger is the gold trigger and how it flexes gold up or down depending on the inflationary environment that we're in. When you package those three things together, you can really deliver something very different from sort of these broader based commodity indices. I think the irony here is these original indices, as Don said, were to provide production-weighted exposure. Think about gold. Not much new gold is produced every year because it's scarce.

15:23And because it's scarce, it gives its value. So if you're only going to invest in stuff as it's being produced every single year, you're naturally going to be underweight a really valuable asset like gold. And so it's kind of fixing that shortfall as well. Who decides what's in the index at these levels? Like, for example, and what's a commodity? Is water a commodity? What about eggs? Are eggs a commodity? Bitcoin is classified as a commodity, but none of these things are in the index. Yeah. So the first step in our index construction is very similar to how Bitcoin and GSEI do it is evaluating liquidity by looking at open interest and volume that trades across various commodity contracts.

16:07By that methodology, there's only 24 commodities that are eligible to be included. Those are the same that are in BCom. So water is not eligible or even some of the other examples. But most things you would think of, it's across a variety of sectors are included. And I think that's remarkable, given how much outperformance we're able to generate by a different methodology. It's done with the same 24 components. It's just a different way of weighting the same 24 things. How much should investors expect there to be movement? Do these relationships, the inflation relationships, change? Or do you think they're relatively static over time and you just kind of let things free flow?

16:49How does the rebalancing work? Yeah, so I meant to answer that as part of the last question. There's not discretionary choices being made in this reweighting. This is all a prescriptive methodology that we came up with four or five years ago. And one of the key things that I always tell my marketer about that in terms of, well, if you've done something prescriptive, then you've got to discount it how it performed in the back test relative to how it's going to perform in real life. I didn't think that was going to be the case because we never looked at the back data when we developed it. We came up with this process about what should be in it, what rules should govern, how it should reweight between scarcity and debasement and gold and the other things without looking at the data, just knowing what a well-constructed thing should look like.

17:35So how did you create the thing? What is the weighting methodology? I was hinted at some of these things earlier. The first step, obviously, to generate what could be included, that's that volume and OI analysis. It seals the same 24 list of possible components that BECOM has. the next step is to create a quality score for each commodity. And the components of that quality score have a couple of different inputs to them. One is this inflation pass-through sensitivity, like how related is a change in the price of that commodity to a change in end user good, because that's what the people probably want to protect against.

18:10Two is just looking at a correlation of that commodity to CPI over different windows. Because again, if it's going to be an inflation hedging tool, there should be some consideration how the price of that commodity changing relates to the change in CPI. And then the last component of that quality score is looking at the cost of carry, like how expensive is it to maintain an investment in that commodity relative to other commodities. And that's basically the shape of the curve. And then the last thing in terms of the weight process that's important is this dynamic reweighting between what type of environment we're in, whether we overweight the consumable commodities or overweight gold.

18:57And the calculus that goes into that is a function of three different indicators. One is roughly how gold is performing relative to copper, using copper as a measure of how much genuine economic growth activity there is and how it's performing relative to gold, which is more of our people concerned about a preservation of wealth. And looking at the price of those two things is one indicator. Second indicator is simply just the shape of the yield curve. As simple as that sounds, we have found that there's some predictive power in terms of what the commodity demand environment is going to look like that's indicated by the shape of the yield curve.

19:44And that is another one of the scarcity debasement indicators. And the third one is basically just looking at the shape of the consumable commodity curves themselves. If they are in general backwardation, the price of the commodity on a spot basis is higher than it's predicted to be in the future. That's a pretty obvious indication of some scarcity. Like there's higher demand right now than there's expected to be going forward. All three of those factor into the general gold overweight or underweight decision. How does the direction of the dollar impact these strategies? The dollar itself isn't an explicit consideration in terms of the weighting.

20:25I would say in general that a weaker dollar is bullish for commodities regardless of what the basket is. And that's primarily a function of that all 24 commodities that I'm talking about that are part of BCOM are considered to be possible parts of our index are denominated in the US dollar. And if consumers from non-domestic consumers are buying in another currency that is getting stronger relative to the dollar, they can afford to pay more in a dollar price without really actually paying more. So in general, commodity demand tends to go up as the dollar weakens. And we have definitely certainly seen that this year.

21:03That's most obvious in commodities that have a higher non-US consumption. And basically, industrial metals probably have, not even probably correlation-wise, have the strongest effect from that. I'm curious, from a 10 ,000-foot view, how you think about the relationship between technology and commodities? Because I guess the hope with technology is that we just become more efficient at all of these things and technology should be a deflationary force. Obviously, the 2020s has put that idea to the test. How do you think about that from a big picture perspective, having this as a strategic allocation?

21:43I wrote a newsletter a way back about the effective AI on commodities. I was coming at it from a bullish perspective that basically you were replacing human resources with like mechanical resources and the mechanical resources is going to need all this commodity supply to run itself. And I believe that's definitely the case. I mean, AI is just going to get better and better the more resources it has to get better. And what resource does it need to get better? It needs power. So it's just logical to me that like the demand for power is going to go way up, way more so than agriculture, because humans aren't going to need food as much as the machines are going to need power.

22:25But the funniest thing was when I ended the newsletter, I actually asked chat GPT what the effect of AI growth is going to be on commodities. And it actually came back with all these answers about how it's going to make the discovery of these things so much more efficient that commodity prices should go down, which I thought was interesting and not really the conclusion I would have come to. And even if technology ultimately is deflationary, like it always has been and always will be. But there are a lot of reasons, I think, why one should at least have a hedge against a worsening inflationary environment with what we're faced today, whether that's deglobalization, decarbonization, de-dollarization, increased deficit spending, dollar weakening.

23:16There's, I would say, at the moment, a very mixed and confusing picture in terms of inflation. And so that's why we think it's prudent to at least hold a hedge against a worse inflationary backdrop. RAOUL PAL, Why isn't electricity a commodity? RAOUL PAL, It is. Power is actually traded. It's very difficult to put power into a long-term index, though, because it's not storable. I mean, that's part of the biggest challenge with some of these alternative electricity sources in terms of storing wind and solar for when you need it. Same thing exists for investing in it. The relationship between the spot price and what it might be two weeks from now varies dramatically.

23:59So it's very hard to buy and hold on an investable basis because of that. Got it. Christoph, you at Harbor see a lot of different areas of investable markets. How are you seeing investors behave when it comes to taking a position at commodities? Do they tend to? I don't know. This probably depends on the investor, but whatever. Too late. I'll ask it anyway. Are there people that are trading? Are there people that are buying and holding? Are there people that are trend following it? How are people investing, getting exposure to commodities? I'd say there's obviously a few different ways. I'd say there's one camp which I would say has more of a strategic asset allocation at the moment, just with what's happened in the 2020s, you know, the shifting environment that we've kind of talked about.

24:46And for those folks, you know, obviously talking about commodities or talking about the merits of the asset class or maybe a better approach to the asset class, those conversations tend to flow more naturally. I would say the biggest cohort and the numbers play this out is people that don't own any commodities and frankly have been burnt by it and don't want to touch it again. So there's a lot of education with those investors. If you look at what commodities did in the 2000s, it was a very, very strong asset class. I think a lot of people went in at the wrong time and then saw commodities do nothing but underperform in the 2010s and kind of swore never again.

25:30And so we just, you know, we spent a lot of time trying to educate those investors on the merits today of the approach that hedger takes, the merits of the asset class as it is today. And really, I think the 2020s is a very different investment environment from the post-financial crisis, you know, 2010 period, where you had a disinflationary, very low interest rate, very kind of benign and stable macro backdrop, where you didn't really need to own anything except equities and maybe some bonds just to provide a bit of protection. Whereas I think today the environment is very different. So what sense do you get is a typical allocation of someone who has a strategic?

26:13Because you mentioned this as an offset to like a 60-40 or a hedge. Are we looking at 5 % to 10 % allocations? What are investors putting in something like this in terms of their overall portfolio? I'd say a little bit less than that is what I'd see. It's funny. We do portfolio reviews. We work with financial advisors, RAAs, and we get that whole portfolio. and we look at it and we do a bunch of analytics on it and run it through a bunch, you know, our different systems and see how we can help them. I've never seen, you know, we do hundreds of these and I've never seen an allocation to commodities where I've gone, oh, that looks, you know, too much.