Additional Diversification for an Investment Portfolio
In the past, the mere mention of “investing in commodities” conjured up images of being fleeced by ruthless speculators in the blink of an eye.
However, over the last few years, the emergence of an wide variety of investible commodity indices and other commodity linked assets have rapidly increased, resulting in an increased demand for commodity based products.
Different Commodity Categories Exist
Commodities consist of raw materials, which are used to create products for consumer use. Commodities include energy products such as oil and natural gas, agricultural products such as corn and wheat, industrial and precious metals, and livestock.
- Energy Crude oil, natural gas, and heating oil
- Precious Metals Gold, silver and platinum
- Industrial Metals Copper, aluminum, zinc and nickel
- Agriculture Corn, wheat, coffee, and soybeans
- Livestock Live cattle, feeder cattle, and lean hogs
In addition, other commodities also known as softs are comprised of items such as cotton, sugar and cocoa that can not be stored for long periods of time.
Ways to Gain Exposure to Commodities
Commodity investments are vehicles used by investors to gain exposure to commodities and commodity futures. There are a number of ways investors can gain exposure to commodities.
Option One: Buying physical commodities
The purchase of the physical commodity is one approach to investing in commodities. For practical purposes, it may not be feasible to an investor to buy and hold actual bushels of corn or barrels of oil. Transactions in commodities carry a high degree of risk, and a substantial potential for loss. An investor should carefully consider whether this type of trading is appropriate in light of their experience, objectives, financial resources and other relevant circumstances.
By Using managed futures, an investor has the option of revolving a commodity continuously
Option Two: Investing in stocks of companies that produce commodities
Investors have the option of owning stocks of a firm that derives its revenue from the sale of physical commodities. Investors may pick a certain sector such as oil and natural gas, mining, or agriculture. A few examples of such companies are oil exploration companies, gold mining companies, companies that specialize in mining minerals or metals, and agricultural companies. In this case, an investor will have to take on significant market exposure from investing in the stock of the commodity producing company. In addition, the performance of the company depends on the movement of the price of the commodities it bases its sales on.
Option Three: Investing in commodities through managed futures or index funds
Managed futures is the most common method used for investing in commodities.In this case, actual physical delivery of the product can be taken but this is typically not standard. By using managed futures, an investor has the option of revolving a commodity continuously without ever having to take delivery of the physical commodity.
As with the purchase or sale of physical commodities, transactions in commodities through managed futures can also carry a high degree of risk, and a substantial potential for loss.
Stocks, Bonds, Bills, REITs, and Commodities
Commodities and REITs have traditionally served to lower the overall risk of a domestic portfolio.
This image illustrates the hypothetical growth of a $1 investment in domestic stocks, commodities, REITs, bonds, and cash over the time period January 1, 1980 to December 31, 2009. REITs were the best-performing asset class over this time period, with $1 growing to approximately $28.15. Stocks came in second, followed by bonds, commodities, and cash.
Commodities and REITs are often overlooked in a portfolio’s asset allocation decision. These assets can be excellent vehicles for diversification purposes, as their returns have demonstrated low or even negative correlation with more traditional assets. In other words, when traditional assets have done poorly, these alternative assets may have done well, thereby reducing the overall volatility (risk) of your portfolio.
A well-diversified portfolio should consist of investments that behave differently.
Correlation is a statistical measure of one investment’s performance relative to another. Asset classes can be positively or negatively correlated, or have no correlation at all. Perfect positive correlation between two assets is represented by+100, while perfect negative correlation is represented by –100. Uncorrelated assets assume the value of 0.
A well-diversified portfolio should consist of individual investments that behave differently. This table above illustrates the correlations for stocks, bonds, cash, REITs, inflation, and commodities since 1980. Analysis of historical data concludes that commodities have negative correlation to bonds and cash, and relatively low correlation to stocks and REITs.
While diversification does not eliminate the risk of investment loss, adding assets with low correlation to the existing assets in your portfolio may soften the impact of market swings, because they do not all react to economic and market conditions in the exact same manner.
Benefits of Including Commodities in a Portfolio
Historically, adding commodities to a portfolio comprised of stocks and bonds has reduced risk and increased return. This image illustrates the risk and return profiles of two hypothetical investment portfolios over the past 20 years. The domestic portfolio with commodities performed better that the domestic portfolio with only stocks and bonds, while at the same time assuming less risk.
By diversifying the original portfolio to include commodities, the overall risk of the portfolio was reduced and the overall return was increased—a win-win situation. Because traditional assets and commodities generally do not react identically to the same economic or market stimuli, combining these assets can often produce a more appealing risk and return tradeoff.
Commodities tend to perform better in years when inflation has increased
Commodities Serve as a Hedge Against Inflation
Unlike stock and bond returns, commodity returns tend to increase in periods of inflation. For example, when the demand for goods and services increases, their prices tend to increase as well. As a result, the demand and prices of commodities, which are used to produce these goods and services, rise as well. The table below represents the annual returns of stocks, bonds, and commodities since 1990. The change in inflation is represented by the percentage change in the consumer price index from one year to another. As seen in this table, commodities tend to perform better than stocks and bonds in the years when inflation is seen to have increased.
It is impossible to predict which asset class will be the best or worst performing in any given year. The performance of any given asset class can have drastic periodic changes. The graph below illustrates the percentage an asset class beat inflation between January 1978 through December 2009, as measured by rolling six month periods. The Goldman Sachs Commodity Index beat inflation over 70% of the time during that period, followed by REITS at nearly 66% and stocks at over 60%. Surprisingly TIPS only beat inflation 52.6% of the time, but the TIPS universe was much smaller in the earlier years of this analysis.
It is impossible to predict the best performing asset class in any given year
Commodity Performance Over the Past 10 Years
It is impossible to predict which asset class will be the best or worst performing in any given year. The performance of any given asset class can have drastic periodic changes. This table below illustrates the annual performance of various asset classes in relation to one another. In times when one asset class dominates all others, it is easy to ignore the fact that historical data shows it is impossible to predict the winners for any given year.
Investors betting on another stellar performance for commodities in 2001 were certainly disappointed, as small stocks rose from one of the worst performing asset classes in 2000 to the best performing one in 2001. Commodities were the top performer again in 2005, sank to the bottom in 2006, and came back to the top position once again in 2007. These types of performance reversals are evident throughout this example.
A well-diversified portfolio may allow investors to mitigate some of the risks associated with investing. By investing a portion of a portfolio in a number of different asset classes, portfolio volatility may be reduced.
Commodities have received attention in recent years as an asset class with potential to outperform traditional assets. Commodity-related investments can serve as a portfolio diversifier and enhance risk-adjusted returns.
Commodities have several characteristics that make them an attractive asset class to include in a portfolio. Portfolio diversification is enhanced when commodities are added to a traditional portfolio due to their negative correlations with stocks and bonds.
- Low Correlation
- Low to negative correlation with assets such as stocks, bonds, and REITS
- Low to negative correlations between individual commodities
- Attractive Historical Returns
- Long-term returns similar to stocks
- Moderately higher risk levels compared to stocks
- Risk Reduction Through Portfolio Diversification
- Including commodity allocation in a traditional portfolio can reduce volatility and improve diversification
- Acts as an Inflation Hedge
- Commodities typically tend to benefit from rising inflation
The positive historical performance of commodities relative to stocks with their moderate risk levels are a few reasons to consider commodities as an investment option. Unlike stock and bond returns, commodity returns tend to increase in periods of inflation. For example, when the demand for goods and services increases, their prices tend to increase as well. As a result, the prices of commodities which are used to produce these goods and services rise as well.
On account of these factors, an addition of commodity allocation may serve a portfolio well.
In 2002, Equitas Capital Advisors, LLC was established as a unique company that blends the resources of a large global corporation with the flexibility of a small boutique firm. The registered service mark of Equitas Capital Advisors is Engineering Financial Solutions® and the purpose of Equitas is to design, build, and deliver investment solutions to meet the goals and objectives of our investors. Equitas Capital Advisors, LLC located in New Orleans, has over 200 years of combined investment management consulting experience providing professional investment management services to investors such as foundations, endowments, insurance companies, oil companies, universities, corporate retirement plans, and high net worth family offices.
Disclosures and Disclaimers:
Above information is for illustrative purposes only and has been obtained from reliable sources but no guarantee is made with regard to accuracy or completeness. It is not an offer to sell or solicitation to buy any security. The specific securities used are for illustrative purposes only and not a recommendation or solicitation to purchase or sell any individual security.
Equitas Capital Advisors, LLC is registered as an investment advisor with the U.S. Securities and Exchange Commission (“SEC”) and only transacts business in states where it is properly registered, or is excluded or exempted from registration requirements. SEC registration does not constitute an endorsement of the firm by the Commission nor does it indicate that the advisor has attained a particular level of skill or ability.
Information presented is believed to be factual and up-to-date, but we do not guarantee its accuracy and it should not be regarded as a complete analysis of the subjects discussed. All expressions of opinion reflect the judgment of the author on the date of publication and are subject to change. This publication does not involve the rendering of personalized investment advice.
Charts and references to returns do not represent the performance achieved by Equitas Capital Advisors, LLC, or any of its clients.
Asset allocation and diversification do not assure or guarantee better performance and cannot eliminate the risk of investment losses.
All investment strategies have the potential for profit or loss. There can be no assurances that an investor’s portfolio will match or outperform any particular benchmark. Past performance does not guarantee future investment success.