Reappraising the case for commodities
Sentiment towards commodities has turned decidedly sour over recent years and investors are questioning the role of commodities in strategic asset allocation. Duncan Lamont, Head of Research and Analytics, returns to first principles and reassesses why commodities could merit a place in portfolios in the first place.
- Commodities have been one of the star performers of 2016 yet investor sentiment has rarely been more negative. Previous poor performance means they remain one of the few asset classes globally that can lay a claim to being cheap
- While downside risks remain, commodities are not only cheap in a historic context but also relative to equities and marginal costs of production
- Commodities provide a hedge against rising inflation that few other asset classes have been able to demonstrate historically. Those that have are currently either very expensive or no longer fit for purpose
- There is a relatively weak relationship between commodities and equities. They can offer significant diversification benefits even if it is unrealistic to expect them to hedge equity market crashes
- Commodity volatility is on a par with equities. However, they can improve expected risk-adjusted returns even on the basis of a relatively conservative return outlook
- Commodities represent a relatively inefficient asset class which offers relatively high potential excess returns for skilled managers.
A rollercoaster ride
Commodity investments have been on a rollercoaster ride. Investor interest sparked into life in the 2000s as a raft of academic research emerged extolling the virtues of commodities as an asset class1.
Historic equity-like returns and significant diversification benefits relative to equity and bonds were key attractions as was the potential inflation-hedging quality of the asset class.
For a number of years, commodities exceeded these expectations as insatiable demand from emerging markets and China in particular spurred a super cycle in commodity prices. Between December 1999 and June 2008, the Bloomberg commodity Index (BCOM, previously known as the Dow Jones-UBS index) delivered total returns of around 15% a year with similar volatility to equities, during a period where equities barely broke even2.
1 “Facts and Fantasies about Commodity Futures” by Gary Gorton and K. Geert Rouwenhorst, Wharton School, University of Pennsylvania, February 2005, is one of the most famous. http://fic.wharton.upenn.edu/fic/papers/06/0607.pdf
2 BCOM was established in 1991 and is more diversified by commodity than the longer standing S&P GSCI index (GSCI, established 1970), which has an over 70% allocation to the energy sector. In this paper we have used BCOM to represent commodity returns where possible as it is more reflective of the broader commodity universe. However, when longer term analysis has been carried out we have used the GSCI as a result of its longer track record.