Commodities in your portfolio

Likewise, it pays to take a shovel to commodities' longer-term record. A study from investment historian William Bernstein provides some useful lessons to would-be investors in metals, crops and energy. One of his key findings was that, while gold and silver did exceptionally well in the inflationary 1970s, they've performed miserably during other market environments

The average annual return on gold since 1970 has been a modest 7.7 per cent, which is below that on long-term government bonds and only a little above long-term annual inflation of 5.3 per cent. Silver has not even managed to maintain its real value, with an average annual return of only 4.3 per cent. What's more, these modest returns were achieved at a cost of massive volatility.

Mr Bernstein also looked at spot prices for 23 different commodities, including cattle, pork bellies, cocoa, heating oil, gold, copper, orange juice, lumber and sugar. Although they, too, had their best years in the 1970s, the returns for the decade were only a few percentage points above inflation. And their long-term average has been considerably below inflation, making commodities the worst performer of all asset classes.

Between 1956 and June this year, the total return from the Commodities Research Bureau index was 399 per cent. However, the S&P rose 2,680 per cent during the same period. The picture is even worse at the level of individual commodity classes: the CRB Metals Index returned just 150 per cent over the period. The bottom line is that, while commodities can deliver breathtaking returns over some years, they can't be counted to beat equities – or even boring old bonds – over the long run.

While returns are what we're most interested in, commodities are a great inflation hedge and are also relatively lowly correlated with equities, offering investors some diversification within their portfolios. As Table 2 below shows, the CRB index and the US Consumer Prices Index have a correlation of 0.78, which is very high. Livestock's correlation with inflation is even higher at 0.85 per cent. These figures – and many other studies telling the same story – clearly demonstrate that commodities broadly defined could work wonders if we’re about to enter a stagflationary era, with gold likely to do especially well.

Investors have also been piling into commodities, tempted by the prospect of positive returns even as equity markets stutter.

Table 1, below, compares a number of equity markets with key commodity classes – the diversification story is compelling, with wheat, oil and gold being particularly lowly correlated with the FTSE. But a slightly more disturbing picture emerges for other commodities – copper's correlation with the FTSE 100, for example, has risen to 0.47 in recent years as more and more mining companies dominate the London Stock Exchange. If that trend intensifies, UK investors could find themselves hit badly as both equities and industrial commodities start falling at the same time.

Research from Blue Sky Asset Management backs up these conclusions – it recently noted that the three-month correlation of wheat and gold as measured by an R2 is 0.22: "This is also seen in the wheat/copper correlation (from 0.09 to 0.23) and the wheat/oil correlation (which has increased from 0.10 to 0.24). This highlights the recent investment trend of lumping commodity markets into one basket – they all go up and they all go down in tandem."

Source: Blue Sky Asset Management

But that correlation is not a static concept. It does change with time and markets – one seminal academic study concluded that during times of extreme market stress, commodities were in fact negatively correlated with equities. "During the 5 per cent of the months of worst performance of equity markets, when stocks fell on average by 9.18 per cent, commodity futures experienced a positive return of 1.43 per cent, which is slightly more than the full sample average return of 0.88 per cent per month... It seems that the diversification benefits of Commodity Futures work well when they are needed most."

It's worth noting that as investor interest in the sector snowballs, the indices themselves are beginning to move broadly in line with each other, even though they contain a very different mix of resources. According to 15-year data (to March 2008) from Barclays and 10-year data from Deutsche Bank, the three main broad commodity indices have an approximate 0.8-0.9 correlation between their returns in the long run.

One concern of many analysts is that commodity markets have fundamentally changed in the past decade. Hedge funds and fund management institutions have piled into the commodity market, causing lasting changes in the nature of demand for commodities and their derivative variations.

These changes open up some potentially serious issues – take gold and the huge success of just one US-based exchange-traded fund (ETF) – the Street Tracks Gold Trust (GLD in the US). Launched just a few years ago, it is already worth a staggering $20bn and sits on 659 metric tonnes of gold. According to one report, this one trust is buying up 13-14 per cent of annual mine supply every year and has more assets than the next five largest gold mutual funds combined. It's also the world's largest trove of gold in private hands. Such a huge concentration of physical ownership raises the possibility that a sudden loss of confidence in gold could spark a run, with the ETF selling huge quantities of gold overnight, causing prices to plummet even further.

Another concern is that commodities have been dependent for too long on the roll yield as a source of total returns – at times it has felt like a one-way trade designed to make endless profits. Recent academic studies of long-term commodity returns by big commodity funds has shown that between 1959 and 2004 the annual return from changes in spot prices has actually averaged just 3.47 per cent – the authors found that most of the long-term reported increase was from normal backwardation (ie. futures prices are below spot prices). What happens if this one-way road to future profits switches and futures prices return to being above spot prices? As William Bernstein points out, this could spell disaster for investors in ETFs and exchange-traded commodities (ETCs) as the producers turn the tables and stop paying for this protection against inflation – ie, stop using forward contracts.

Many investors have been put off specialised products such as commodities and foreign exchange by the perceived risks and volatility of pricing. But with broad markets volatility is actually fairly subdued and the risk premium not that different from equities. A recent paper from Yale analysed long-term returns and found that: "The historical risk premium on commodity futures is about the same as the risk premium on S&P 500 stocks, and more than double the risk premium of bonds.... The volatility of the equally-weighted commodity futures total return is slightly below volatility of the S&P 500." The spot prices of individual commodities may be high, but the total return indices seem to flatten some of that volatility.

TABLE 1: commodities v the rest

TABLE 2: commodities spread risk well