“It’s Different This Time”

Most investors are familiar with the claim “It’s different this time” – a siren’s song, often heard right before the inevitable collapse of whatever was supposed to be different. We heard it in spades with the dotcom craze. At its essence, it is a rationalization for chasing performance (against one’s better judgment) and is usually all you need to hear before knowing you need to go the other way – fast.

So where is this harbinger of doom rearing its head these days? We believe in the commodities market. It’s no surprise that strong global growth and demand for natural resources from emerging economies have caused commodity prices to soar the past couple years. And there is little reason to think these forces will abate any time soon.

As a result, many consultants have recommended that their large institutional clients (pension and endowment funds) allocate a portion of their assets to funds that provide direct exposure to commodities (energy, metals, agriculture, etc) as a new permanent asset class. With this recent performance burst, the pitch is that commodities can provide as good or better returns as stocks, but with less risk. Hear the sirens?

This pitch is alluring because in this post-bubble environment, investors are keen to allocate their funds to places that promise good returns but protect them from devastating bear markets. Hence, the enormous cash flow that has been directed into real estate, hedge funds and now commodities.

All very logical, but unfortunately, fraught with risk. First, if an investment in commodities is so attractive, why is it that no one was making this case until after they had made this extraordinary move, after languishing the better part of a decade? Now they want us to be buyers. This is the most dangerous aspect of “it’s different this time” – declaring the pricing cycle dead … at the peak of a cycle. This should send chills down any investor who bought the same logic about unlimited demand for bandwidth seven years ago (see WorldCom, Quest, Level Three, Global Crossing, etc).

The conclusion that all portfolios should have a strategic allocation to commodities is also flawed. History shows that an increase in demand will eventually be met by an increase in supply and higher prices will inevitably temper demand. A recent study by Alliance Bernstein Research also found that when the energy component is stripped out of commodity returns, the results are less than stellar and the diversification component is significantly weakened.

In the end, there will be times when exposure to a diversified basket of commodities will do as advertised, and times when it won’t. Determining the timing of that is called portfolio management, and in our view, there is nothing profoundly different about that.