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- [00:00]
A
Today's Animal Spirits Talk youk 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.
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B
Welcome to Animal Spirits, a show about markets, life and investing. Join Michael Batnik 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. Clients of Ritholtz Wealth Management may maintain positions in the securities discussed in this podcast.
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C
Welcome to Animal Spurts with Michael and Ben. Is the dollar bull market over? Ben?
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A
Sure. Seems like it's definitely taking a punch on the chin. Correct.
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C
A punch on the chin.
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A
That doesn't sound right.
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C
That doesn't sound right.
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A
Taking it on the chin.
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C
Take it. Well, one of the things that benefits with a weakening dollar or 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. What are you talking about? Not a prediction. It's going higher.
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A
It's up to the commodity does moving higher. I guess people are luring about inflation again.
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C
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.
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A
Don't you think it's because that we've been in this essentially sideways market for commodities prices for the big ones like oil and such that that probably that yeah, investors are right or wrongly just assuming that this is going to continue.
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C
Well, one of the things about 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.
- [02:19]
A
Right. And that's what a lot of people think that the, the benchmark, it's kind of like bonds like, like The S&P 500 is hard to beat but the bond is index if you just take on some more credit or duration. But it's not that hard to beat. But the 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, whatever, when it started. And a lot of people think that there's a better way to do it.
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C
Because it was for suppliers and hedgers.
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A
Right.
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C
Like it wasn't meant as an investable index.
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A
Right. So on today's show we talked to Don Castro who is the CIO at Quantix Commodities and they work with Harbor Capital. So we have Christophe Gleichan 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 weighting 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. So here's our talk with Don and Christoph.
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C
All right guys, welcome to the show.
- [03:28]
D
Great to be here.
- [03:30]
C
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?
- [03:45]
E
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. So 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.
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A
Okay, so 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?
- [04:22]
E
Well, the two most common benchmarks for commodity indices are originally was the S and P gsci. Now more commonly I think the Bloomberg Commodity index has become the more common benchmark for commodities. Both of those share a similar history in terms of their construction. They were created primarily to generate offsetting flows for banks. Commodity desks in their producer book Hedging, it was pretty much one sided risk at the desk at those times, which is basically hedging the exposure of commodity producers with no offsetting buyers. 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. As such, their weights were basically just world production weighting because they were trying to offset the producer Hedging that they had, 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. It's 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? In most cases that's some diversification from a 60:40 portfolio in a way that is going to be effective in hedging inflation. Approaching it from that perspective results in a slightly different commodity weighting to your basket.
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A
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?
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E
The creation of the BCom and the GSCI was designed to make it an investable asset class. I mean, obviously you 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. So 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.
- [06:48]
D
And that got, if I can just sort of jump in, that's what really got my attention and our attention. So just to back up quickly, at Harbour 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, whether 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, they're pretty awful over the long run. And 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. You have to torture any kind of optimization or mathematical model. And what was interesting here, 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. 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.
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C
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?
- [08:25]
E
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. Part of the other challenge that we face with commodity investing is a lot of investors are, and 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, we recognize the shortcoming of the existing benchmarks. We think commodities can be an effective tool in hedging against inflation. Coming out of the pandemic, we really think we are going to be in that environment. We believe in your skill set to develop something that can be very effective in that we'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, that's really where this was born, this idea of like, okay, 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 quantics Commodity Index came from.
- [09:37]
D
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, you know, 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.
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A
Pretty good timing on the launch, huh?
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E
Yeah, I wish we could have been around a little earlier so that people could have bought it when they needed it.
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A
So what is the. I mean, to my mind, oil seems to be like the biggest one. But like, what are the biggest differences here? What are you over underweighting versus some of these other benchmarks?
- [10:19]
E
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 of key points. 1 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 BCOM basket represent a wide range of refinement. You have something like cotton, which is basically pure cotton, just comes off the bale a long way from anything that you would actually use in terms of how that cotton is made. Even the price of a T shirt, which is the most basic implementation of cotton, it's only 5% of the price of that shirt is the cotton. Where another commodity that's in the BCOM index, RBOB gasoline, is what we trade on. What is primarily traded under the component of the BCOM index in gasoline is the same stuff that you put in your tank. If that goes up in price, the consumer is going to feel it right away. 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. And the process of doing that, if there's a contango in the curve, that is the futures curve is predicting it to get more expensive. The investor doesn't get those gains, they pay that in 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 that cost of carrying. 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. So we own more heating oil distillate and RBOB 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. Reasons for that are a little bit different in that we envision this being something that's durable and appropriate for a long term strategic investing. There's not every environment where commodities are so tight that inflation is likely to be caused by scarcity. 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 could become costly over the long term. In 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. So another key element of our design is dynamically reweighting between consumable commodities and storable commodities. Basically gold in terms of a safe asset.
- [13:53]
D
So for a commodities novice like me, I'm not a commodities expert like Don is. If 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 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. And 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, that we're in. When you package those three things together, you can really deliver something very different from 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, and because it's scarce gives it its value. So if you're only going to like 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.
- [15:39]
C
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 or eggs a commodity? Bitcoin is classified as a commodity, but none of these things are in the index.
- [15:53]
E
Yeah. So the first step in our index construction is very similar to how bigcom and GSCI do. It is evaluating liquidity by looking at open interest and volume that trade across various commodity contracts. By 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 said 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.
- [16:39]
A
How much should investors expect there to be? Do these relationships, the inflation relationships change or do you think they're relatively static over time and you just let things free fall? How does the rebalancing work?
- [16:51]
E
Yeah, 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. 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. And then when we came up with the rules, we ran it back and it had 8% over BCom outperformance over the previous 20 years. And since it's been live, as Christoph knows, It's outperformed by 8 and a quarter percent even better than it did in the back test because we didn't. There's probably some rules you could have come up with if you looked at the data that would have been even better. But that's not how we created the thing.
- [17:58]
C
So how did you create the thing? What is the weighting methodology?
- [18:02]
E
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 yields the same 24 list of possible components that BCOM 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 and end user. Good, because that's what the people probably want to protect against two 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, is looking at the cost of carry. How expensive is it to maintain an investment in that commodity relative to other commodities. And that's basically the shape of the curve. 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. That 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 a Are people concerned about 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. And that is another one of the scarcity debasement indicators. And the third one is basically just looking at the shape of the curve 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. 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.
- [20:38]
C
How does the direction of the dollar impact these strategies?
- [20:43]
E
The dollar itself isn't an explicit consideration in terms of the weighting. I 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. That'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.
- [21:43]
A
I'm curious kind of 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 2020-has put that idea to the test. How do you think about that from a big picture perspective, having this as a strategic allocation?
- [22:07]
E
So I wrote a newsletter a week back about the effect of AI on commodities and I was coming at it from a bullish perspective. Basically you were replacing human resources with mechanical resources. And the mechanical resource 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 the demand for power is going to go way up, way maybe more so than agriculture because humans aren't going to need food as much as the machines are going to need power. But the funniest thing was when I ended the newsletter, I actually asked ChatGPT what the effect of AI growth is going to be on commodities. 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.
- [23:12]
D
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 face today, whether that's de globalization, decarbonization, de dollarization, increased deficit spending, dollar weakening, 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 more a worse inflationary backdrop.
- [23:53]
C
Why isn't electricity a commodity?
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E
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. So it's very hard to buy and hold on an investable basis because of that.
- [24:28]
C
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 in commodities? Do they tend to. And I know this probably, probably depends on the advancer, but whatever, too late. I'll ask it anyway. Does it. Are there people that are trading? Are there people that are buying, holding it? Are the people that are trend following it? How are people investing, getting exposure to commodities?
- [24:54]
D
I'd say 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 2000s, you know, the shifting environment that we've kind of talked about. And for those folks 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. You know, if you look at what commodities did in the 2000s, you know, 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. And so we just, you know, we spend 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 2000 and 20s is a very different investment environment from the Post Financial Crisis 2010 period where you had a disinflationary, very low interest rate, very 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's very different.
- [26:32]
A
What sense do you get is a typical allocation of someone who has a strategic. Because you mentioned this as an offset to like a 60, 40 or a hedge. Are we looking at 5 to 10% allocations? Like what are investors putting in something like this in terms of their overall portfolio?
- [26:48]
D
I'd say a little bit less than that is what I'd see. Like, it's funny, we do portfolio reviews, like we work with financial advisors, raas and we 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 our different systems and see how we can help them. I've never seen we do hundreds of these and I've never seen an allocation to commodities where I've gone, oh, that looks too much. And so always single digits and always I would say low single digits. So if I see a portfolio and someone's got like 4 or maybe 5% in commodities, I'm like, oh, they like this asset class. But often what you'll see is like a 1 or 2% hold in the asset class, if you see it at all. I would say still today the vast majority of allocators have zero to commodities.
- [27:44]
E
I can explain why that's the case. I mean, to put some numbers on what Christophe was saying earlier. From the end of 2000 through today, the B COM index, the excess return is down 13% over 25 years. Now, the same commodities and the same weights, if you look at their spot prices, like what it actually costs you to buy the 24 things that are in there, it's up five times. And that's probably consistent with what you guys kind of feel and know like gasoline is definitely more expensive than it was then. Copper is more expensive than it was then. Yet the index that's supposed to have been providing you protection against that is down 13% over 25 years. Why would you allocate to something like that, Don?
- [28:30]
A
Because I think since if you use 2000 as a start date, which is like the peak of the dot com bubble, but whatever, I think gold is either right in line with the S and P or it's outperformed. What would you just say to someone who says, you know what I'm just going to put my commodity allocation is going to be gold as opposed to a diversified portfolio of these different commodities. What would you say to that? What's the benefit of adding these other commodities?
- [28:52]
E
Great question. The answer to that. There's great examples of that. Even in the last four years since we've been live with the index that hedger tracks, there are examples of idiosyncratic risk, geopolitical shocks that can occur that are unpredictable in terms of their timing. So you need to have that exposure at all times to really capture those things. The Russian invasion of Ukraine I think caught everyone by surprise. And basically you looked at the cost of distillate heating oil, jet fuel type things doubled in two months. That's an inflationary shock that you would be missing and not have been protected against if you were only allocated to gold. Even this year, gold captures a lot of headlines. It's not even the top performing commodity of 2025. It's not even the top performing precious metals. Silver has outperformed gold, but bean oil has also outperformed gold. Even live cattle doesn't get a lot of airtime. It's a small commodity, but it's in. Bcom is up 25% outperforming gold this year.
- [29:57]
D
I think. Just let me add on this so I've got the numbers in front of me. In 2021, when BCom so broad commodities basket was up 27%, precious metals were down minus 6. And in 2022 when commodities were up 18%, precious metals were flat. They were basically zero. So those are two back to back years if you, if. And those are the years that you really want commodities to be in your portfolio. If you've just got a very, you know, concentrated view and only owning precious metals, you may be opening your investors up to some nasty surprises. And that's why I just think having this diversified but highly convicted expertise in driving your commodities allocation makes a ton of sense.
- [30:50]
C
One of the things that used to happen that doesn't seem to happen anymore are oil spikes after geopolitical instances, which was one of the key reasons, at least historically, to be exposed to these areas. Certainly BCom, where it's a huge, a huge component of it is energy. Talk about that dynamic.
- [31:10]
E
I think the biggest reason it stopped spiking is because in every geopolitical potential supply scenario, there was never actually a loss of supply. And I think it's like the boy who cried wolf. Eventually the market just got numb to the threat. Like we've heard this before, but we never actually lose supply. I think that's a logical conclusion, one I believe in myself. But at some point that's not going to be the case. There's going to be an event where we actually do lose supply. And what people were fearing when they were buying it to begin with will actually be reality. The midi supply shock is way down on the list of things you could be potentially bullish about. For commodities though, even though that one is unlikely to play out, that's not a reason not to buy.
- [32:02]
A
Guys, is there anything else that we didn't cover that you wanted to hit on today?
- [32:06]
D
No, I just, I'd say for, for, for me from an asset management perspective, I think what's interesting is like this approach that we've talked about. If we were doing this 10 years ago, this would have been available in an actively managed mutual fund. But just how the industry has shifted, how investor preferences are shifting. There's a really interesting kind of merging of, of active and passive or active and index investing. And I think this is a great example of where we're trying to meet investors where they are today, which is clearly they have a preference over index investing. Index doesn't mean passive because you can see in this index approach I describe as very, very active. It's high tracking error to BCom, and it's been designed to generate meaningful outperformance versus BCom. Perfect.
- [32:54]
A
Where do we send people who want to learn more?
- [32:56]
D
They can go to our website, HarperCapital.com perfect.
- [33:00]
A
Thanks so much, guys.
- [33:01]
D
Thank you.
- [33:02]
E
Thanks.
- [33:04]
A
Okay. Thanks to Don. Thanks to Christoph. Remember, check out harborcapital.com to learn more. Email us animalspirits at the compoundnews. Com.