Swedroe: Commodities Can Diversify Risk

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.”

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.