Great, thanks so much. So don’t forget everyone, please put your questions in the Q & A and not in the chat, but we do have some pre-submitted questions that we received before the webinar. So, oops. And I’m not sure who will want to take this one here first, but this came from Andy, and he asked, “Do you think commodities are a good buy right now?”
Yeah. So, it’s a similar question to the one before, but I will start off answering that one in this way. Commodities have been used by investors to act as a partial hedge against inflation risk. And here we mean unexpected inflation because you don’t need a hedge against expected inflation, that’s already built into bond prices and into equity prices. So, it’s only the unexpected you need a hedge against, and you can get an inflation shock because you have a negative supply shock. So, oil embargo in 1973/1974 of course followed by the Arab/Israeli war, that was a negative supply shock. Commodities can act as a hedge against that kind of risk. That’s really a geopolitical risk, not an inflation risk, but it does help of course, because commodity prices rising are a sign of inflation. So, you could just get inflation in general, and prices go up.
Commodities on the other hand are awful to own when you have a negative demand shock like we had in 2008, and energy prices collapsed. So, you have to be prepared to take the good with the bad there. The last comment I will make is this. Well, I’ve got two more comments: 1) the only true hedge against inflation is to own tips or treasury inflation-protected security. They will move one to one with inflation. So, if your goal is to hedge inflation, that’s the best hedge, and 2) the second-best hedge is to shorten your bond maturity so you’re not subject to rising interest rates which typically of course follow higher inflation. So, you can shorten that maturity, but then you give up what’s called the term premium. Commodities are only the third best hedge. And then there’s even a problem with commodities because the research shows that commodities tend to do well when they’re trading in what’s called “backwardation,” a technical term that means that the spot price is higher than the futures price.
So, let’s say the spot price today is $125 and the futures price is say $110. Okay? So, the way you buy commodities is you buy them in the futures market. And so you’re buying at $110 in the futures market, the spot is $125. Even if the price stays the same or goes down a little bit, you’re going to come out ahead. And when commodities have traded in backwardation, you have this tailwind and on average they have done well. It doesn’t mean they always do well. It’s just an average. However, a lot of the time they’re trading on what’s called contango. Contango happens when the spot is, say $125 and next month contractors is $130. Now the price has to rise five dollars for you just to break even. And on average, when commodities are in contango, guess what? That headwind creates a drag, and they tend to perform poorly.
So, if you’re going to invest in commodities, you have to think about, “Do you want to be jumping in and out depending upon whether it’s in contango have all that trading and monitoring, and it doesn’t always work. And if you’re out of it, when it’s in contango, you just gave away your quote inflation hedge anyway. The last comment I’ll make on that is commodities, like gold, which is a commodity tend to do very well in very short bursts and then do very poorly for a very long periods of time—10 or even 20 years. And my experience is most investors can’t tolerate those very long periods just to capture that insurance when they need it. So, what happens is they buy commodities and then it does very poorly say from 2008 through 2020, and then they yell at their advisor, “Why did you buy this?”
They get out. And then of course, you get an incident and commodities run-up, but they’re not there. So, if you’re going to invest in commodities, you have to be disciplined, patient as well, be willing to stay the course, and basically recognize you’re getting low expected returns because you’re buying insurance. So that’s a problem. My own preference today, if I were concerned about inflation, is to move out of safer intermediate bonds, which is the typical kind of asset we buy. So, you might buy a 4- or 5-year ladder of municipal bonds or CDs, but today those are very low yields because of the fed has been suppressing yields. So instead of earning, say one, one and a half percent on that portfolio, you can shift to a fund we recommend called Cliffwater Alternative Lending Fund that invests in middle-market loans. It doesn’t have much liquidity, but it’s current yield is 7% and 7 ¼, and its floating rates. So, every month the yields adjust. If rates go up because of inflation, then yields will go up.
So, there you’re earning a huge premium of about 6%. You are taking some credit risk, but historically these are very conservative loans within average default history of just 60 basis points. And even during the pandemic, when stocks were dropping 30 to 40%, and high-yield risky bonds got hammered, this fund only lost about 3%. So, you are taking some downside risk, but not a lot in return for two benefits: 1) hedging inflation to some degree because if we get inflation, yields will go up and 2) you’re earning this 6% massive premium by giving up that liquidity. So, that would be my recommendation. I would not generally recommend for most people commodities, but I don’t have a problem as long as you understand that this is the history. There are going to be very long periods where it does poorly, like the period from 2008 through 2020, which was a terrible period for commodities.