- Commodities provide inflation protection and valuable diversification benefits to traditional core stock and bond portfolios, but adoption has been muted, with a major concern disappointing performance in benign inflation environments.
- Traditional commodity indices suffer from a lack of diversification, particularly from a large concentration in the energy markets, and from exposures that do not adjust with market conditions.
- Commodity index design, and correspondingly the long-term expected performance of the index, can be improved in two important ways: weighting and contract selection.
Commodity markets have served a critical function of risk mitigation and risk transfer for thousands of years. In fact, derivatives trading in commodities was formalized in one of the first recorded legal codes, the Mesopotamian Code of Hammurabi, around 1750 BC (Oldani, 2008, p. 2–3). Today, as in the past, commodities play a key role in controlling risk for both commercial businesses and investors. Being real assets, commodities provide inflation protection and valuable diversification benefits to traditional core stock and bond portfolios. Yet adoption by both individual and institutional investors remains relatively limited for a variety of reasons, which include their “exotic” standing among asset classes, essentially, a fear of the unfamiliar; the perceived complexity of investing in futures contracts; and the performance headwinds of traditional, long-only commodity indices, such as the first-in-its-class S&P GSCI.
While having delivered substantial protection against rising inflation, traditional commodity indices have produced disappointing returns in benign inflation environments, encouraging many investors to think twice about a strategic allocation to commodities. That said, a long-only commodities portfolio can be a compelling long-term investment, assuming it is designed in a way that reverses the curse of unnecessarily poor returns by taking advantage of robust sources of excess return. In this article we review the case for commodities and the design advantages of the Dow Jones RAFI™ Commodity Index.
The Positive Attributes of Commodities
Most individuals and businesses hold insurance policies to mitigate the high costs associated with unexpected events, such as car accidents, home fires, lawsuits, and medical diagnoses. Some types of insurance are mandated by law (e.g., car insurance), but the majority of policies are voluntarily purchased. Insurance premiums are a necessary expense for often (after the fact) unneeded insurance, but a cost well worth bearing if the event insured against unfolds. The same largely applies to commodities: the asset class acts as a diversifier because of its low correlation with other asset classes as well as acts as insurance against rising inflation due to its positive correlation with inflation (Greer, 2006). Looking back almost a half-century from January 1976 to June 2016, the monthly correlation of the S&P GSCI with the S&P 500 Index was 0.17, and the monthly correlation of the S&P GSCI with the US Consumer Price Index (CPI) was 0.46.
Commodities as diversifier. Adding a 5% commodities allocation to a traditional 60% US core stock/40% US core bond portfolio (i.e., 55% stocks/40% bonds/5% commodities) can markedly reduce volatility. Over the period January 1979 to June 2016, the volatility reduction, or the simple difference between the rolling three-year volatility of a 60/40 portfolio and the 55/40/5 portfolio, lowered overall portfolio volatility by an average of 53 basis points (bps) a year. In the late 1990s, the diversification benefit rose to over 100 bps. The sole exception of commodities not adding any benefit was during the global financial crisis when every asset class moved downward in unison.
Traditional Commodity Indices
Commodities as inflation protection. We can assess commodities’ inflation protection ability by looking at performance (i.e., insurance payout) during periods of high inflation, which we define as 3% or greater, occurring in roughly one-third (62 of 199) of the trailing 12-month periods during these years. The average excess return (net of the risk-free rate) of a US 60/40 portfolio is a relatively low 1.4% compared to 24.2% for the S&P GSCI over the period January 1999–June 2016. But when inflation was low, defined here as less than 3%, the first-generation commodity index generated an average return of ?7.3%.
Where Traditional Commodity Indices Fall Short
Given that traditional commodity indices have generally delivered on their diversification and inflation-hedging benefits over the last 40 years, what explains the muted adoption by investors? In a word: performance. If we plot the growth of $100 from January 1976 to June 2016 invested in the S&P GSCI, US 60/40 portfolio, US T-bills, and US CPI, the commodity index’s ending value of $595 underperforms both the 60/40 portfolio ($5,015) and T-bills ($691), and beats inflation ($430) by only $165 as of the end of June 2016. The annualized performance of the S&P GSCI was 4.5% compared to 10.2% for the 60/40 portfolio and 4.9% for T-bills. The annualized inflation rate over the period was 3.7%. Simply put, investors in the S&P GSCI earned a return lower than T-bills despite being subjected to annualized volatility of nearly 20%.
Traditional commodity indices suffer from two drawbacks that negatively impact their performance: 1) a lack of diversification and 2) exposures that do not adjust with market conditions.
Lack of diversification. The weighting methods of traditional indices solely based on measures such as world production values—the Bloomberg Commodity (BCOM) index being a notable exception—tend to create very large tilts toward energy markets. The sizeable energy concentration of traditional commodity indices can lead to significant risk of large downturns when macroeconomic events adversely impact the energy markets, such as in 2008 when the S&P GSCI fell 46.5%, and again in 2015 when it dropped 32.9%. Six separate commodity contracts are associated with energy, but with the single exception of natural gas, all are very highly correlated with crude oil, being derived directly from it.1 Therefore, by focusing so heavily on one highly correlated sector, investors are foregoing meaningful diversification benefits.
Ignoring market conditions. In the 1920s John Maynard Keynes developed the theory of normal backwardation. Keynes argued that commodity producers would theoretically be willing to pay a premium to buyers of commodity futures in order to hedge away the risk of falling commodity prices in the future. He argued that it would be normal for commodity futures prices “out on the curve” to be below the spot price, and named this condition backwardation.2
Whereas backwardation may seem a logical market outcome, commodities also exhibit a condition called contango, the opposite of backwardation, in which the spot price is higher than the futures price out on the curve. Nowadays, many commodities are frequently in contango due to storage costs and shifting relationships among suppliers, producers, and speculators, and this contango is usually steepest at the front of the curve. The traditional commodity index construction repeatedly buys the most liquid front-month futures contracts, which induces a high cost of rolling contracts in times of contango and generates significantly negative roll returns.
Improving Commodity Index Design
Commodity index design, and correspondingly long-term expected performance, can be improved in two important ways: weighting and contract selection.
Weighting. An overweight to commodities in backwardation (or in less-extreme contango) in order to capture a relatively high and attractive