Commodities have a role to play in investors’ portfolios – but perhaps no more so than gold.
To see this, consider the performance of two reasonable diversified portfolios: one comprising 30 per cent UK equities, 30 per cent overseas equities and 40 per cent gilts; and the other comprising 24 per cent each of UK and overseas shares, 32 per cent gilts and 20 per cent commodities, as measured by the S&P GSCI. Since January 1996, the former has given an annual average return, excluding dividends, of 5.4 per cent in sterling terms with a standard deviation of 8.4 percentage points. But the one with commodities has given a return of 5.5 per cent with a standard deviation of 7.5 percentage points. That’s more return for less risk.
Now, I wouldn’t set much store by the uplift in returns. The last 20 years have seen great returns on commodities, thanks largely to strong growth in China and falling interest rates. These are unlikely to be repeated in coming years. But the decline in risk is significant. It reflects the fact that commodities sometimes do well when equities do badly – such as in 2000-01 and in 2011. Thanks to episodes such as this, commodities help to reduce portfolio risk even though they are volatile in themselves.
But they don’t always do so. In 2008-09, for example, they fell sharply at the same time that equities did. They were no help as a diversifier then – although gilts certainly were.
Another asset, though, was – gold. In the 12 months to February 2009 UK equities and the GSCI both fell by more than 30 per cent. But gold rose more than 30 per cent in sterling terms, thanks in part to sterling’s slump. In really bad times, then, gold beats general commodities as a diversifier.
We can quantify this. If we replace commodities in our notional portfolio with gold, portfolio volatility falls from 7.5 to 7.1 percentage points (with, for what it's worth, higher returns too). This reflects the fact that gold has been negatively correlated with both UK and overseas equities while commodities have been positively correlated. Gold, then, does a better job of mitigating equity risk.
There’s a simple reason for this. Many non-gold commodities are cyclical: they rise with rising expectations for global economic growth and fall with falling expectations thereof. Because such fluctuations also generate moves in share prices, this causes equities and general commodities to be positively correlated. Because gold isn’t cyclical, it doesn’t share in these fluctuations and so is a better diversifier against fears of recession.
Gold has been negatively correlated with both UK and overseas equities while commodities have been positively correlated
Because general commodities are cyclical, they are an especially poor diversifier against other cyclical assets, such as emerging markets. Looking at annual changes in sterling terms since 1996, the correlation between the S&P GSCI and MSCI’s emerging markets index has been a hefty 0.57. That between gold and emerging markets has been 0.3, implying a little more diversification power.
Much the same is true for Aim shares. These also tend to be cyclical because they are driven by investor sentiment. And this generates a positive correlation with the S&P/GSCI – of 0.49 since 1996. Their correlation with gold, however, has been a mere 0.07. For Aim investors, therefore, gold is a better diversifier than general commodities.
Investors wishing to spread risk should therefore look more to gold than to general commodities. This is especially true if you hold lots of emerging markets or Aim stocks.
Let’s put it this way. There are two situations in which commodities might do well as equities do badly. One would be if the UK suffers a local economic difficulty that drags down share prices and sterling while the rest of the world’s economy does okay. Another would be if equities fall because they have been overpriced – this happened most spectacularly in 2000-01.
Now, the former is a possibility – if, for example, we crash out of the EU while China and the eurozone recover later this year. But the latter seems unlikely; the fact that the dividend yield on the All-Share index is above its long-term average suggests that shares are not overpriced.
What’s more, there are two different scenarios in which equities and commodities might both do badly. One would be if fears increase of a global recession. The other would be if central banks raise interest rates. This might hurt equities by reversing the 'reach for yield', and commodities by increasing the opportunity cost of holding them. (Although gold might also suffer in this scenario.)
Net, then, it’s not easy to see commodities being a greater diversifier against equity risk in the near term.
This doesn’t add up to a case for ditching them. Their correlation with equities would be an advantage if or when we see expectations of a recovery in China, as this might see both equities and commodities do well. If you are looking for a way of spreading equity risk, however, gold is probably a better bet than general commodities – although not a foolproof one.
