Are Commodities Speculation or an Investment?

The extreme outperformance of commodities over the last several weeks has sparked interest in this asset class. New research finds that commodities are subject to lottery-like returns, providing information on future performance.

Academic research has found that there are investors who have a “taste,” or preference, for lottery-like investments – those that exhibit positive skewness and excess kurtosis. This leads them to irrationally (from a traditional finance perspective) invest in high-volatility stocks (which have lottery-like distributions), driving their prices higher, resulting in poor future returns – they pay a premium to gamble.

If the markets were perfectly efficient, arbitrageurs would drive prices to their right levels. However, in the real world, limits to arbitrage, and the costs and fear of shorting, can prevent rational investors from correcting mispricings. The low-beta/low-volatility anomaly (low-beta/low-volatility stocks have higher risk-adjusted returns than high-beta/high-volatility stocks) is an example of the lottery effect, with mispricings persisting.

Academic research, such as the 2020 study “Lottery Preference and Anomalies,” has found lottery-like distributions in IPOs, penny stocks, extreme high-beta stocks, small-growth stocks with low profitability and high investment, financially distressed stocks that are either in or near bankruptcy, and even in horse racing, where long shots are systematically overvalued. The research has also found that the anomaly returns are mainly driven by the short leg of lottery-like stocks – relating the anomaly to short-sale constraints. Those constraints prevent arbitrageurs from correcting mispricings (stocks with high lottery features have lower short-sale volumes on average, and investors are reluctant to short sell them, which exacerbates their mispricing).