August 16th, 2017 | by Gregg S. Fisher, CFA, "Invest with Reason"
Is There an Investment Case for Down-and-Out Commodities?
- Amid broad gains across global asset classes year to date, commodity returns have continued their long run of lackluster performance in 2017.
- Despite challenging absolute and relative performance and high volatility, commodities have a strategic role to play in a diversified portfolio.
- Owing to their low correlations with traditional asset classes, commodities can dampen overall portfolio volatility by moving differently from core portfolio holdings like stocks and bonds.
- Gerstein Fisher research found that historically, a 5% allocation to commodities was particularly beneficial during extended periods of poor equity markets, enhancing portfolio returns during the worst 3-, 5-, and 10-year periods of equity returns from 1970 to 2017.
With virtually every major asset class around the globe having risen, it seems that even a dart-throwing monkey would have prospered so far this year from his investment picks. Global equities (as measured by the MSCI All-Country World Index), for example, were up 15% as of August 7, and the S&P 500 Index gained 12% during the same time frame. The outlier here is commodities, down 7% (S&P GSCI index of commodities) for the year as of the same date.
Commodity prices have been mired in a slump for years. Since the bottom of the Financial Crisis in March 2009, $1 invested in the S&P 500 Index would today be worth $4, whereas an investment in the S&P GSCI index lost one-third of its value. My interest in commodities is not due to an expectation of an abrupt turnaround (I make no forecasts or market-timing attempts). Rather, it stems from some basic principles of portfolio construction.
Different Asset Classes, Different Roles
Building a long-term, diversified portfolio is an exercise in combining asset classes with low or negative correlations. Gerstein Fisher recently conducted research into commodities’ role in a portfolio and we found that, considered on their own, commodities seem quite inferior to equities: from January 1970 to July 2017, the S&P 500 Index returned 10.4% annualized to just 6.8% for the S&P GSCI. Additionally, equities’ return came with nearly one-quarter less volatility than for commodities (I should note that assets that are expected to “pay off” during bad times—Treasuries are another example of these— typically have lower expected long-term returns). Yet when added to a portfolio of stocks and bonds, this volatile asset class can still enhance a diversified portfolio’s risk profile.
To understand why an asset class (like commodities) may zig when stocks and bonds zag, it helps to think about underlying economic factors. For instance, if there were an unexpected jump in inflation, we would anticipate that commodities would perform well, while stocks and certainly bonds would suffer. In this scenario, commodities would serve to dampen overall portfolio volatility. Historically, this has been the case; our research shows that in periods of rising interest rates (which often coincide with rising inflation) back to January 1970, commodities did significantly outperform equity markets.
Thus, as a result of low correlations with stocks and bonds, commodities have historically played a helpful role in a multi-asset class portfolio—even considering nearly a decade of notably poor returns in the asset class. Exhibit 1 illustrates how a small allocation to commodities improved total portfolio risk-adjusted returns.
In addition, when we analyzed all 5-year rolling return periods from January 1970 to 2017 (more than 500 observations), we found that, whereas a 5% allocation to commodities only improved returns of a balanced portfolio in just under one-half of periods, it reduced portfolio volatility in 98% of the 5-year periods. Furthermore, we found that commodities (5% allocation) were particularly useful during extended years of poor equity markets: they enhanced portfolio returns during the worst 3-, 5-, and 10-year periods of equity returns from 1970 to 2017. I invite you to review all of the findings in our recently posted commodities research paper, Commodities and a Diversified Portfolio.