A Short Guide To Commodities Investing

January 24, 2015

UCEndowmentUsesPassiveAvtiveBlendInvestors have traditionally turned to commodities because of their diversification effects and as protection against inflation. Often considered to be real assets, commodities perform very differently from other asset classes over the economic cycle, historically providing low-to-negative correlations with stocks and bonds. In addition, they provide substantial protection during periods of crisis, such as wars and stock market crashes. Commodities have been attractive because they don’t always behave like more traditional assets, but they can come in vehicles—such as futures—that don’t look much like those used to access traditional assets. So how should an investor approach commodity investing?

Lately, commodity returns have disappointed, with asset prices sagging this summer and inflation remaining below the Federal Open Market Committee’s 2 percent target. In addition, they dropped sharply during the worst of the global financial crisis. But over the longer term, the Merrill Lynch Commodity Index has outperformed inflation, global equity and hedge fund benchmarks from the end of 1997 through June 2014, as can be seen in Figure 1.

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A Good Diversifier
Commodities’ long-term benefits are well-documented: In an award-winning paper, Claude Erb and Campbell Harvey found that commodity futures that periodically rebalance can offer similar expected returns and historical Sharpe ratios as equities, in their view based largely on the diversification effect of combining individual commodity futures in a single broad index. The paper, which was published in the Financial Analysts Journal,1 also found substantial support for the inflation protection capabilities of certain commodity futures, e.g., heating oil, copper and cattle.

Commodities’ diversification effect is apparent in the last 15 years, producing low correlations with other asset classes—only 0.44 to equities and 0.17 to sovereign bonds from January 1999 to July 2014, as can be seen in Figure 2. Relative to a classic 60/40 portfolio of U.S. stocks and bonds, commodities has only a 0.3 correlation—slightly higher than the 0.2 correlation of inflation-protected bonds, but lower than the 0.6 correlation of U.S. real estate to the balanced portfolio.

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