Do Commodities Belong in Your Allocation?

By Geoff Considine

April 8, 2014

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For much of the last several years, poor performance from commodities has hurt investors’ portfolios, a result of depressed interest rates, low inflation and slow economic growth. Any diversification value they provided was masked by strong equity-market performance. My analysis shows that only a small allocation to commodities is justified, and advisors can obtain most of the same benefits with real-estate investment trusts (REITs) or individual Treasury inflation-protected bonds (TIPS).

I’ll begin with a review of the key research on commodities as an asset class, followed by a discussion of a number of representative funds that provide diversified exposure to commodities. In the final section, I’ll present Monte Carlo simulations of the portfolio impact of adding commodities funds to a traditional stock-bond allocation.

Research on commodities as an asset class

The market price of a basket of commodities should increase roughly in line with inflation, but why would there be returns beyond this? While the spot prices of commodities tend to track inflation, futures contracts of commodities have historically delivered positive returns.

John Maynard Keynes laid the foundation of modern thinking on commodity futures markets . He proposed that investors in commodity futures are providing risk capacity to the producers of commodities by allowing them to lock in a fixed price for commodities to be delivered at a future date. In other words, investors in future contracts are essentially insuring commodity producers against a decline in prices in the future.

Investors can benefit from purchasing a futures contract at a discount to the expected future spot price. As the delivery date approaches, the futures price should rise to meet the spot price. This, in turn, means that the forward curve (the prices of futures contracts as a function of delivery date) should fall as the time to delivery increases. This situation is referred to as backwardation.

But what if futures contracts are more expensive than the spot price for a commodity? A second theoretical argument posits that commodities futures prices are expected to increase through time to create an incentive for investors to build and maintain storage facilities. If later-dated contracts are more expensive than near-term contracts, the shape of the futures curve is called contango. Storage adds value for consumers of commodities. For agricultural commodities, production tends to follow a seasonal cycle but demand may be constant year-round. Storage allows producers to sell their crops when they are harvested and maintain a constant supply for consumers. For energy commodities, production may be constant year-round, but demand may be seasonal. Prices will adjust to make it worthwhile for investors to provide stability of supply.

In both cases, there is an expected positive return to investors by being long commodity futures contracts.  These two broad concepts as to why long-only commodity investors, or investors who only bet that commodity futures prices will tend to rise as they approach the expiration date, should expect positive returns are referred to as the theory of backwardation and the theory of storage.

The empirical research demonstrating the value of investing in commodity futures focuses on fully collateralized futures strategies. Buying a futures contract means that an investor agrees to purchase a certain amount of a commodity at a specific price at the settlement date. A fully collateralized futures purchase means that the investor concurrently buys Treasury-bills in an amount equal to the purchase price of the futures contract. This means that there is no risk the buyer of the contract will be caught short of cash needed at the settlement date.

Historical analysis of commodity futures suggests that investors have, indeed, reaped attractive risk-adjusted returns. In a now-classic paper from 2005, Facts and Fantasies about Commodity Futures, Gary Gorton and K. Geert Rouwenhorst, both of the Yale School of Management, found that a diversified fully collateralized (e.g. zero-leverage) basket of commodities futures has historically provided returns comparable to equities. In addition, such a strategy has delivered returns that are negatively correlated to equities, which means that a combination of equities and commodities in a portfolio provided substantial diversification benefits.

This analysis used data from 1959 to 2004. An equal-weighted annually rebalanced portfolio of commodity futures provided return of 11.2% per year (arithmetic average return of 11.97% per year) in this 45-year period, with average inflation of 4.1% per year. The spot price of a buy-and-hold portfolio of these same commodities provided a return that was effectively equal to inflation. The authors concluded that commodities futures provided an effective hedge against inflation along with equity-like returns and that the benefits of a fully collateralized commodity futures strategy cannot be achieved via investing in the equity of commodity producers.

Another important piece of research on commodity futures strategies is The Tactical and Strategic Value of Commodity Futures, by Claude Erb and Campbell Harvey of Duke University. The paper confirmed that a diversified rebalanced portfolio of commodity futures has historically generated returns comparable to equities, but with some important caveats that investors need to understand. Perhaps the most striking finding in this paper was that the compounded return for futures on individual commodities was near zero.

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