Investors typically look to a commodities allocation to provide three key benefits to their portfolios: diversification, inflation protection and return potential. But for many investors, the return benefit of commodities has been difficult to grapple with amid challenging performance in recent years. We believe investors should not extrapolate this recent experience into the future because commodity returns tend to be cyclical. While the last few years of commodity returns are not an aberration, they are also not the norm. Commodity asset class returns tend to go through cycles of positive and negative performance, which largely coincide with economic growth cycles.
Take a long-term perspective on returns
We believe that, when evaluating the ongoing return potential of commodities, investors should take a longer-term perspective of performance. To illustrate, Figure 1 compares the rolling three-year return of a 55% equity/40% bond/5% commodity portfolio versus a 60% equity/40% bond portfolio.
The relative performance of the portfolio containing commodities has varied over time, with periods of underperformance occurring as expected during economic downturns. Commodities as a whole are growth-sensitive assets, especially in recessions that coincide with plentiful commodity supplies and weak demand – exactly what occurred during the global financial crisis. Importantly, these periods were followed by years of recovery in commodity returns and the outperformance of the 55/40/5 portfolio.
It is also important to note that commodity returns may be enhanced through active management. Commodity markets offer a fertile opportunity for active trading and potential for alpha generation for capable investment managers (see “Adding Value with Commodity Alpha Capabilities,” July 2014). And while the return benefit of including commodities in a broader portfolio can be cyclical over time, the diversification benefit has remained consistently positive, which led to better risk-adjusted returns over time. As Figure 1 shows, the volatility of the 55% equity/40% bond/5% commodity portfolio has been below that of the 60% equity/40% bond portfolio during various economic cycles over the last 45 years.
Correlations between commodities and other asset classes have subsided
The correlation of commodities to equities saw a temporary pickup in the aftermath of the global financial crisis. This was the result of the decline in aggregate demand that uniformly affected many asset classes, resulting in higher correlations among them. However, commodities have returned to responding more to fundamental supply factors. These can include weather, which affects natural gas and grains prices, geopolitical instability, which influences crude oil, or mining strikes, which affect metals. Importantly, these factors do not tend to affect stock or bond market returns to the same degree, and accordingly, correlations between commodities and other asset classes have come down. Recent correlations have also declined across individual commodities as the markets have come out of the global financial crisis.
Figure 2 illustrates the low correlation between commodity sectors, which stands in stark contrast to generally high sector correlations within other asset classes – here equities as an example. This is further evidence that supply fundamentals are once again taking over commodity returns, as each commodity is responding to its own idiosyncratic conditions rather than to the effect of aggregate demand on the entire asset class.
Commodities may provide a valuable inflation hedge
Finally, in terms of the overall portfolio benefit, commodities should offer an effective means of helping hedge a portfolio against inflation shocks. Looking at the composition of the Consumer Price Index (CPI), food and energy make up approximately a quarter of the basket. However, changes in inflation, especially unexpected changes, are driven primarily by food and energy. Said differently, food and energy drive most of the CPI’s volatility. It is this unexpected volatility that is especially harmful to stock and bond returns. The commodity asset class, on the other hand, has a positive correlation to changes in inflation as it is the very same commodities comprising the asset class that drive the majority of CPI changes. Furthermore, commodities tend to exhibit an outsize response to inflation, meaning that when inflation increases above expectations, commodity returns increase more than the change in the inflation rate. So to the extent that inflation surprises to the upside, a commodity allocation can provide a potential hedge against inflation beyond just the original dollar amount invested.
Commodities continue to have a place in many investors’ portfolios
Despite the most recent performance challenges, commodities still offer the potential benefits of providing inflation protection, improving portfolio diversification and enhancing risk-adjusted returns. Moreover, investors can look to supplement the return potential of commodities by selecting managers with a proven history of delivering alpha in this asset class.
The writers would like to thank Shawn Coffman for his contribution to this article.
