Exactly how much could a commodities allocation have benefited portfolio returns and reduced risk in 2010? We crunch the numbers to find out.
The past 12 months have been pretty good for financial assets. Blue chips in the S&P 500 Composite have gained 15.5 percent since March 30 last year. Domestic bonds, too, have appreciated. Before coupons, the Barclays Capital Aggregate Bond Index has risen 5.2 percent.
The advances in physical assets—the stuff that's supposed to provide an inflation hedge—have been even more dramatic. The S&P/Goldman Sachs Commodity Index is 21.1 percent higher than it was a year ago. Oil is up 26.9 percent and gold's 27.9 percent is above its year-ago price.
That hedge business is becoming more important as investors smell the aroma of inflation wafting from the Consumer Price Index and other metrics.
Our Monetary Inflation Index (the 365-day rate) returned to positive territory back in January, after an eight month-sojourn into disinflation.
U.S. Inflation Metrics
Inflation is corrosive to financial assets, and in times like these, investors tend to pile into their hard assets hedges. But what is a proper hedge? If you're fully invested in financial assets, you need to raise cash from some asset sale to afford a hard asset allocation. Does that come from stocks? From bonds?
And what do you buy with your proceeds? Broad commodity exposure? Gold? Oil?
To answer the "where" question, we need to look at the correlation of commodities to stocks and bonds. To keep things neat, we'll measure the S&P 500 Composite (SPX) and the Barclays Capital Aggregate Bond Index (BCAgg) against the S&P/Goldman Sachs Commodity Index (GSCI), London gold and spot WTI (West Texas Intermediate) crude oil.
Replacing bond exposure with commodities increases your volatility, but maintains a similar level of "counter-stock" correlation benefit. Replacing stock exposure with commodities may lower your volatility, but given the relatively high correlation between stocks, may provide less diversification benefit. Ultimately, investors need to decide what they're hoping to achieve with their commodities exposure.
Next, you have to ask what size your hard asset hedge should be. Dealers have long recommended a 5-to-10 percent allocation to hard assets, so who are we to argue? Let's try a 10 percent slug.
Now, we have to determine what to buy. Perhaps past performance can give us some insight. We'll look back over the past 12 months.
Starting with an old-fashioned 60-40 portfolio—60 percent stocks, 40 percent bonds—we'll peel off a 10 percent hard asset allocation from each side and compare the results. To keep things tidy, we'll use the same benchmarks as before.