Swedroe: Commodities Can Diversify Risk

May 15, 2014

Over this particular period, they found low, but significantly positive, correlations between the S&P 500 stock index and commodity indices. Precious metals were the exception, showing no significant correlation with stocks. They concluded: “Precious metals should be best suited to complement a stock-only portfolio.”

They then analyzed the benefits of commodities for mixed stock/bond portfolios. They found that nominal return bonds are significantly negative correlated with industrial metals, energy and the aggregate commodity index, but uncorrelated with precious metals, livestock and agricultural products.

Their conclusion?

“Commodities might be able to improve the out-of-sample risk return structure of a multi-asset portfolio. Due to the relatively large Sharpe ratio and significantly negative correlation with bonds, industrial metals, and the aggregate index seem more promising than livestock and agricultural products.”

More specifically, they found: “While industrial metals, precious metals, and energy improve the Sharpe ratio of a stock-bond-portfolio for most asset allocation strategies, we find little or no portfolio benefits for livestock or agricultural commodities. Thus, the often criticized investments in food products seem to be superfluous for efficient portfolio diversification.”

Because commodities are often used as a form of portfolio insurance, it’s important to add that they found: “Commodities do reduce portfolio tail-risks measured as value-at-risk or maximum drawdown.” Additionally, they also found that “The Sharpe ratio measures reveal that the GSCI aggregate commodity index and industrial metals consistently improve the risk-return profile of a stock-bond-portfolio for all asset allocation strategies.”

On the other hand, they found: “Interestingly, the popular commodity, gold, offers lower portfolio benefits than the aggregate precious metals index.”

Another important find: “Sub-period analyses suggest that the portfolio benefits of commodities are time varying and the benefits of commodity investments vanished in the most recent crises period when commodity prices declined and did not provide the expected diversification benefits.”

Of course, time-varying benefits are true for all asset classes.

The bottom line is that the authors reached this conclusion:

“Our empirical results suggest that an aggregate commodity index improves the risk-return profile of a stock-bond-portfolio for almost all analyzed investment strategies.”

It’s important to note that they reached this conclusion despite the fact that the period they studied was one in which the inflation-hedging properties of commodities weren’t needed. For the 27 years covered by their study, the Consumer Price Index never exceeded 4.1 percent, and averaged just 2.8 percent.

Owning commodities was like buying insurance which wasn’t needed. Despite this, they found that including commodities in a stock/bond portfolio was likely to improve risk-adjusted returns.


Larry Swedroe is director of Research for the BAM Alliance, a community of more than 130 independent registered investment advisors throughout the country.

 

 

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