Swedroe: Commodities Can Diversify Risk

May 15, 2014

You have to look closely, but commodities can definitely improve risk-adjusted returns.

The 2006 publication of Gary Gorton’s and K. Geert Rouwenhorst’s study “Facts and Fantasies about Commodity Futures” spurred an increase in the interest of using the asset class of commodities to enhance the performance of financial portfolios. In fact, commodity investments more than doubled from roughly $170 billion in July 2007 to $410 billion in February 2013.

The explanation for the rapid growth was that commodities could provide important diversification benefits—commodities have low correlations with both stocks and bonds. The low correlations are partly explained by the fact that commodities are correlated with different factors such as weather, geographical conditions and supply constraints.

In addition, commodities have been shown to hedge the risks of unexpected inflation, tending to perform best during periods of rising inflation, when nominal return bonds do poorly.

Commodities also have been shown to hedge supply shocks that negatively impact stock returns, such as during the oil embargo of 1973-74. But owning commodities doesn’t shield investors from demand shocks to the economy, such as during the recessions of 1981, 2001 and the financial crisis of 2008.

In other words, the reason to consider including commodities is that they act as a form of portfolio insurance.

Wolfgang Bessler and Dominik Wolff, authors of the April 2013 study “Do Commodities Add Value in Multi-Asset-Portfolios?” analyzed the portfolio benefits of commodity investments. Of particular interest is that they distinguished between different groups of commodities such as energy, precious metals, industrial metals, livestock and agricultural products.

They employed seven different asset allocation strategies, including naive diversification rules such as 1/N or strategically weighted portfolios. They examined relatively sophisticated asset-allocation strategies such as risk parity, and optimization strategies such as minimum variance and mean variance.

Overall, they studied how the addition of commodities to mixed stock/bond portfolios impacted the returns and risk-adjusted returns of the portfolios. Stocks were represented by the S&P 500 Index, bonds by the Barclays U.S. Aggregate Government Bond Index and commodities by the S&P GSCI series. Their study covered the period 1986-2012. When considered in isolation, they found that:

  • All commodity investments are substantially riskier than bonds and similarly risky as stocks.
  • The average risk-free rate during the period from 1986 to 2012 was 3.8 percent per year, which is larger than the average return of agricultural products and livestock, resulting in negative Sharpe ratios for these commodity classes.
  • The Sharpe ratios of all other commodity groups are lower than the Sharpe ratios of stocks and bonds, suggesting that commodities are not attractive as a stand-alone investment for long investment horizons.

However, the authors noted: “Even if commodities do not appear to be an attractive asset class as a stand-alone investment, they might add value in a portfolio context by improving the risk-return profile, if correlations with the traditional asset classes are low or negative.”



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