Commodities: Out of favor but still important to a diversified portfolio

November 13, 2014 Categories: Economic Insights
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Let’s face it: commodities are out of favor. After a lackluster 2013, commodities (represented by the Bloomberg Commodities Index) continued their slide in 2014 down -11.83% in the third quarter and down -8.68% for the year to date ending October 31, 2014. It is times like this when investors might begin to reconsider why they hold a commodity allocation at all. In fact, many do abandon ship during an asset class’s darkest days and unfortunately, this may result in the dreaded selling low and buying high syndrome that we humans are so good at!

Instead, I suggest we revisit the value of having – and keeping – a strategic allocation to commodities as part of a well-diversified portfolio. After all, in most cases investments in commodities are not a short-term tactical move but rather part of a long-term strategic allocation based on the principles of diversification and the long-term benefits commodities can provide.

Historically Low Correlation

Commodities haven’t always been the black sheep of asset classes. In the year 2000 while we were all adjusting to the fact that the world didn’t end with Y2K, the Bloomberg Commodities Index returned a strong 31.84% whereas, the Russell 1000® Index was down -7.79%. Even a small exposure to commodites could have helped to offset the U.S. large cap equity losses.

Turns out, although the scenario from 2000 doesn’t always play out that way – with commodities beating U.S. equities – commodities have historically often moved in a different direction from equities.

As you can see in the chart below, histotically, commodities have  fallen somewhere between fixed income and real estate in their 10-year correlation to U.S. equity.

Sources: U.S. Equity - Russell 3000® Index, Bonds - Barclays U.S. Aggregate Bond Index, Commodities - Bloomberg Commodity Index, Real Estate - FTSE EPRA/NAREIT Developed Index.

Sources: U.S. Equity – Russell 3000® Index, Fixed Income – Barclays U.S. Aggregate Bond Index, Commodities – Bloomberg Commodity Index, Real Estate – FTSE EPRA/NAREIT Developed Index. Index performance is not indicative of the performance of any specific investment. Indexes are not managed and may not be invested in directly.

Global Basket

Another potential diversification benefit of commodities is that they are global: the performance of a basket of commodities has historically not necessarily tied to the economic or political conditions of any one country. Of course, the performance of some individual commodities is more closely tied to a specific country than others, but in aggregate across the broad range of commodities, the returns have historically been less likely to be severely impacted by a single country crisis than you may think.

 

Bloomberg Commodity Index 2014

More than just oil and gold

Investors are reminded on a daily basis of how the price of oil or demand for gold is moving. But a diversified commodities portfolio can be composed of more than just oil and gold. For example, the Bloomberg Commodities Index tracks the price of commodities such as Agriculture (e.g. soybeans, coffee, sugar), Energy (e.g., Natural gas, brent crude, unleaded gas) and Metals (e.g. Copper, Silver, Nickel).

Bloomberg sub-indices

As of 10/30/2014. Index returns represent past performance, are not guarantee of future performance and are not indicative of any specific investment.

The bottom line

Wouldn’t it be nice to be able to time movements in and out of asset classes perfectly so that your clients only hold those assets that are rising and can sell them just before they decline? Alas, that’s simply not possible. And that’s why diversification can be a long-term investor’s – and advisor’s – ally. A diversified portfolio composed of asset classes with different return patterns can help weather the inevitable ups and downs of the market – and can help your clients stick to their long-term plan.

1 Correlation coefficients, which can range from 1.0 to -1.0, measure the degree to which the movements of two variables are related. A correlation coefficient of 1.0 means that two variables move in a completely synchronized manner, while -1.0 means they move completely opposite. A coefficient of zero means that movements are completely unrelated. Combining asset classes with lower or negative correlations may help reduce the volatility of returns over time.

Diversification does not assure a profit and does not protect against loss in declining markets.

Exposure to the commodities markets may subject the investment to greater volatility than investments in traditional securities, particularly if the investments involve leverage. The value of commodity-linked derivative instruments may be affected by changes in overall market movements, commodity index volatility, changes in interest rates or sectors affecting a particular industry or commodity and international economic, political and regulatory developments. The use of leveraged commodity-linked derivatives creates an opportunity for increased return, but also creates the possibility for a greater loss.

Bloomberg Commodity Index Total Return contains the following sub-indexes represented in the chart: Unleaded Gas, Natural Gas, Heating Oil, Brent Crude, WTI Crude Oil, Sugar, Soybean, Soybean Oil, Livestock, Live Cattle, Lean Hogs, Cotton, Corn, Coffee, Cocoa, Wheat, Tin, Silver, Platinum, Nickel, Lead, Gold, Copper, Aluminum and Zinc.

The information, analyses and opinions set forth herein are intended to serve as general information only and should not be relied upon by any individual or entity as advice or recommendations specific to that individual entity. It is not intended to constitute legal, tax, securities, or investment advice, nor an opinion regarding the appropriateness of any investment, nor a solicitation of any type. Anyone using this material should consult with their own attorney, accountant, financial or tax or consultants on whom they rely for investment advice specific to their own circumstances.

The Russell 3000® Index: Measures the performance of the largest 3000 U.S. companies representing approximately 98% of the investable U.S. equity market.

Bloomberg Commodity Index Total Return: 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.

Barclays U.S. Aggregate Bond Index: An index, with income reinvested, generally representative of intermediate-term government bonds, investment grade corporate debt securities, and mortgage-backed securities. (specifically: Barclays Government/Corporate Bond Index, the Asset-Backed Securities Index, and the Mortgage-Backed Securities Index).

FTSE EPRA/NAREIT Developed Index is a global market capitalization weighted index composed of listed real estate securities in the North American, European and Asian real estate markets.Barclays U.S. Aggregate Bond Index: with income reinvested, generally representative of intermediate-term government bonds, investment-grade corporate debt securities and mortgage-backed securities.

Indexes are unmanaged and cannot be invested in directly.

Returns represent past performance, are not a guarantee of future performance, and are not indicative of any specific investment.

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