Commodities: revisiting their role in a diversified portfolio
Commodities markets (represented by the Dow Jones-UBS Commodity Index) had a busy first half of 2012: they experienced one of the largest pullbacks in recent history and then rebounded strongly in June, closing out the first half of the year at -3.7% YTD. This volatility served as a reminder that commodity futures are economically-sensitive investments and can move quickly in response to developments in the global economy. The ongoing European financial crisis, signs of a China slowdown, softness in U.S. economic data, and the headwind created by a strong U.S. dollar certainly influenced commodity futures. There were also a number of fundamental developments, such as unexpected weather patterns pushing up agricultural prices and signs of slowing demand trends in industrial commodities markets.
Despite the recent volatility, investments in commodities can still play a useful role in a well-diversified portfolio based on the diversifying nature of their return drivers; their potential for growth; and their historical relationship as an offset to inflation.
Diversifying nature: the table above shows how commodity and equity performance cycles (represented by DJ-UBS Commodity Index and Russell 1000® Index, respectively) have often occurred on different schedules. With the exception of the financial crisis in 2008, large corrections in commodities prices have not occurred at the same time or with the same magnitude as related corrections in equities. This difference in cycles can be particularly beneficial during periods of economic stress.
Growth potential: the demand for commodities is closely linked to global economic progress. As developing markets grow, their requirement to buy steel, copper and materials for new roads, buildings and the supporting infrastructure grows too. Finally as household wealth increases, families seek to have more meat and protein in their diets, which increases demand for agricultural commodities.
Historical relationship with inflation: historically, commodity prices have had a tendency to rise during periods of strong inflation. Investors concerned about rising inflation, particularly those with significant bond holdings that can be negatively impacted in such times, have historically appreciated the important role of commodities in offsetting inflation risk.
Lee Kayser is an Associate Portfolio Manager, Commodities.
Commodities are volatile investments on their own and should form only a small portion of a diversified portfolio to aid in diversification and as a potential hedge against inflation.
Russell 1000® Index: measures the performance of the large-cap segment of the U.S. equity universe. It is a subset of the Russell 3000® Index and includes approximately 1000 of the largest securities based on a combination of their market cap and current index membership. The Russell 1000 represents approximately 92% of the U.S. market.
Dow Jones UBS Commodity Index: Composed of futures contracts on physical commodities. Unlike equities, which typically entitle the holder to a continuing stake in a corporation, commodity futures contracts normally specify a certain date for the delivery of the underlying physical commodity. In order to avoid the delivery process and maintain a long futures position, nearby contracts must be sold and contracts that have not yet reached the delivery period must be purchased. This process is known as “rolling” a futures position.