During the past two years, we’ve seen a persistent decline in the value of the U.S. dollar against other major currencies, particularly the euro and the British pound. At the same time, commodity prices have been rising. But are commodity prices really rising, or are the increases merely a reflection of the dollar’s decline?
First, let’s look at three indexes used to measure changes in commodity prices. The Standard & Poor’s Commodity Index consists of 17 commodities in five sectors—energy, metals, grains, livestock and fibers. S&P weights its index according to the value of commodity contracts for domestic industrial use traded on U.S. commodity exchanges. Not surprisingly, energy (crude oil, natural gas, gasoline, heating oil) accounts for about 55 percent of the total index.
Goldman Sachs maintains an index commonly called the “GSCI.” The GSCI is a world-production weighted index composed of 24 commodity futures contracts. Because it’s production-based, energy dominates the GSCI even more than the S&P Commodity Index—almost 75 percent.
To achieve better diversification, the Dow Jones-AIG Commodity Index tracks 19 commodities in seven sectors. It limits the index weighting of any given commodity to 15 percent and of any given sector to 33 percent. These restrictions give the Dow Jones-AIG Index better representation in sectors other than energy. The Dow Jones-AIG has become the most popular index for commodity-linked mutual funds, particularly the Pimco Commodity Real Return Fund (symbol PRRIX).
To determine the impact of the declining dollar on commodity prices, I prepared a spreadsheet comparing the price history of the Dow Jones-AIG Commodity Index and the changes in exchange rates of the euro and British pound over the past two years. I was surprised to learn that, expressed in both pounds and euros, commodity prices fell significantly during 2005 and 2006. In the case of the euro, the decline averaged 7.2 percent annually, while in pounds, the decline was just under 5 percent annually.
I’ve been concerned about commodities as an investable asset class for some time. It’s clear that commodity prices are highly uncorrelated to stocks or bonds. And, according to “modern portfolio theory,” low asset class correlation is an important tool for reducing risk while striving for investment returns. But, I’m not yet persuaded that a long position in commodities has any positive expected return.
How would someone have fared the past two years by investing directly in currencies rather than through a commodities index fund? In a recent column [“Currency Plays,” December 2006], I explored some new exchange-traded funds (ETFs) as vehicles for currency investments. At present, we have only a limited performance record for the new ETFs.
Rydex “CurrencyShare” ETFs have been available for the British pound and the euro (and six other currencies) since June 2006. Over the ensuing 18-month period, the cumulative return for one holding the British pound fund (symbol FXB) was 16 percent, compared to 12.4 percent for PRRIX. The euro CurrencyShare fund (symbol FXE) did even better—up 18.3 percent.
Predicting changes in currency exchange rates is notoriously difficult. Although it sounds nice, having one’s currency increase in value can cause significant pain. As manufactured goods become more expensive for foreign buyers, industry and employment suffer, dampening economic growth. These and other factors tend to undercut an appreciating currency and lead to a reversal of the trend. Likewise, a weakening currency tends to increase both growth and employment as one’s goods become more competitive in foreign markets.
If the dollar should recover against the euro and pound over the next two years, expect commodity prices denominated in dollars to fall accordingly.
An important difference between investing in currencies is that the currency investor gets paid current, short-term interest rates. Presently, ETFs tracking the euro are paying investors about 4 percent, and those tracking the pound more than 5 percent, both net of fund expenses. This compares favorably to commodity index fund PRRIX, which is yielding a net of about 2 percent on the Treasury Inflation Protected Securities (“TIPS”) that serve as the collateral required for the futures contracts in which the fund invests.
Another tax advantage of currency ETFs: While current interest is taxable as ordinary income, any gain resulting from a favorable move in the currency against the dollar is taxed as capital gain and only due when the position is sold. Commodity mutual funds, like Pimco Commodity Real Return, end up distributing their gains once or twice a year as ordinary income.
The wise investor who wants to bet against the dollar should probably do it directly, through a currency ETF, rather than use a commodity index mutual fund.
