Is now the time to diversify with commodities?

The commodities market, as measured by the Bloomberg Commodity index, fell by 54 per cent from April 2011 to February 2016. This was triggered by a slowdown in industrial consumption from growing emerging nations, in particular China, which had absorbed so much commodity produce in the prior two years that the index had risen 56 per cent.

This volatility in the commodities market did nothing to aid its use as a growth asset or a hedge against inflation, which it can also be. It still provided diversification benefits, as its correlation to equity markets remained weak. However, many saw it as reckless to hold on to a weak asset even in the name of diversification.

Now on the other side of the slump, commodities could be called back into use, particularly as bonds, a more natural diversifier, look to be entering a period of volatility and potential losses.

According to Rory McPherson, head of investment strategy at wealth manager Psigma Investment, now is an exciting time to be looking at commodities for both capital growth, inflation hedging and diversification.

The argument for growth and inflation hedging is built around the tendency for commodities to do well in two stages of the economic cycle.

The first is the early expansion phase – as economic growth is often fuelled by industrial production, demand and prices for raw commodities go up. Second is the late maturity stage, when inflation rises as do interest rates. Commodity prices, in particular food and energy, are embedded within inflation, meaning either their prices rise with inflation or their price rises cause inflation. Either way, owning the asset is positive from a returns perspective.

Currently, central banks in most developed markets have looked at economic growth rates and rising inflation levels and raised interest rates. This potentially late-cycle economy we could be entering is a period when commodities have historically performed well.

“The agricultural and energy commodities look really good now,” Mr McPherson says. “The latter has been a poor performer, but now even other energy commodities apart from oil are looking strong.”

Ben Seager-Scott, chief investment strategist at wealth manager Tilney Group, says he understands why some investors may be allocating more to commodities in the current climate, although he has not done so for Tilney clients.

“If you have concluded that the recent price volatility has made some commodities look cheap, and that we’re in a late cycle where inflation is going to rise, then they are a good hedge,” he says.

However, Mr Seager-Scott urges caution. He says owning commodities as an inflation hedge only works in an environment where prices are rising faster than central banks can increase rates, an environment he does not believe we are in yet. In addition, demand for commodities could be scuppered by trade tensions between the US and emerging markets and China, where most commodity demand, and exports, comes from.

He adds: “They also tend not to give a yield so they can sometimes struggle in a rising interest rate environment as income investors will turn elsewhere. This can be hard to match with them being a hedge for inflation.”

Due diversification

What makes commodities a good diversifier is that individual commodity prices are affected by different factors. This means the factors that affect the price of wheat do not affect the price of zinc and visa versa. Thus, a basket of commodities is itself diversified and so the addition of this basket to a portfolio of equities and bonds should help as the underlying assets all march to their own beat.

To understand its impact on a portfolio, we need to look at the correlation coefficient of commodities to equities and bonds. This figure measures how one asset matches the performance of another. A figure of -1 means that as one rises, the other falls by the same amount – perfectly uncorrelated. Zero means no connection between the two, and 1 means they rise and fall perfectly in tandem.

Over 15 years, the Bloomberg Commodity index has a 0.48 correlation with global equities, measured by the MSCI All Country World index. A positive figure is expected, given that commodities and equities both tend to do well in the expansion stage of the economic cycle, but it is still a relatively low correlation, being closer to 0 than 1.

Commodities' correlation with bonds is also relevant given any allocation to commodities from a diversification perspective would likely come at the expense of bonds. Over 15 years, global bonds as measured by the Bloomberg Barclays Global Aggregate index and commodities have a 0.38 correlation.

The 15-year figures may not fill investors with absolute confidence on diversification benefits, however there are some anomalies to consider – particularly those created by the financial crisis, quantitative easing and the skewing of the bond market, and the severe bear market for commodities.

Over the shorter term, such as three years, commodities and bonds have a correlation of 0.23 and commodities and equities 0.22. Over one year, the figure for bonds and commodities falls to 0.01 – an almost perfect diversification figure. For equities, it rises to 0.44. However, this can be explained by the volatility created by trade war tensions – which affected both share and commodity prices.

It is also worth analysing how an allocation to commodities would affect a portfolio. We ran two portfolios alongside each other to see the effect. Portfolio 1 has a 60 per cent allocation to the MSCI AC World index and 40 per cent to the Bloomberg bond index. Portfolio 2 has the same 60 per cent equity allocation but 30 per cent in bonds and 10 per cent in the Bloomberg Commodity index.

Over one and three years, Portfolio 2 has provided a better return, but over five, 10 and 15 years Portfolio 1 outperformed. Turning to volatility, over one year Portfolio 2 was less volatile, but over three, five, 10 and 15 years, Portfolio 1 was superior.

Portfolio returns

Source: FE Analytics, as at 6.08.18

This is expected as the inclusion of commodities between 2012 and 2016 would have affected portfolios, whereas bond markets were quite strong and less volatile.

However, it is in equity bear markets that investors want diversification to work its hardest, hoping that plunging share prices will be mitigated by asset values rising elsewhere in the portfolio. The MSCI AC World index has been through five periods of falling 10 per cent or more since August 2000, and in three of those Portfolio 2 outperformed. One period when it did not outperform was between April 2015 and February 2016 – the tail end of commodities’ own bear market.

Portfolio returns

Source: FE Analytics

“Putting them in your portfolio, not at a big weight, will reduce the overall level of risk,” Mr McPherson says. “They have very low movement and relationship with bonds and equities.”

Mr Seager-Scott is less optimistic about the advantages. His concern is the correlation between physical commodities and commodity and mining stocks, which can feature heavily in portfolios. Commodity prices and mining company share prices are correlated given the outlook for the company depends on the value they can extract from the raw materials. The FTSE 100 has over 20 per cent in commodity-related companies, while the MSCI AC World index has 12 per cent.

Funds to access commodities

Specific situations need to arise for commodities to perform, but nonetheless the current macro environment could well support the asset class, enabling it to boost performance and mitigate losses from bonds in an inflationary environment. However, investors should not bank on commodities to drive a portfolio’s growth, and should allocate no more than 10 per cent to them.

One consideration when allocating is whether to go active or passive. Exchange-traded commodity funds (ETCs) do exist to provide passive exposure, but there is less than a handful of active funds as many closed during the bear market between 2011 and 2016 as assets under management dwindled. Both buy derivatives known as futures – which is a contract to purchase a commodity at a given price at a specific date in time. This is safer than buying physical commodities given the need to store them. Futures contracts are also rolled into new contracts before maturity to avoid this.

If going passive, there are two main indices you can track: the Bloomberg Commodity index and the S&P Goldman Sachs Commodities index. However, the largest, most liquid exchange-traded funds (ETFs) track the Bloomberg option.

The index includes 22 commodities and bases the allocations on economic production of each material and the liquidity of futures contracts. It does not weight based on the price of the commodity, and rebalances annually. As it stands, its highest weightings are to gold, at 11.6 per cent, copper at 9.1 per cent and crude oil at 8.5 per cent.

The Invesco Bloomberg Commodity UCITS ETF (CMOD) tracks the Bloomberg index and is one of the cheapest and largest funds available. It has an ongoing charge of 0.19 per cent, but also includes a swap fee of 0.15 per cent as it invests using derivatives. It currently has around $1.3bn (£1bn) in assets under management, with daily liquidity and a trading spread better than rival products'.

The iShares Diversified Commodity Swap ETF (COMM) also tracks the Bloomberg index and has $1.2bn in assets under management, but has a slightly higher trading spread and lower daily trading volume than its Invesco counterpart. However, it does not have a swap fee and is available for the same ongoing charge of 0.19 per cent. The performance difference between the two ETFs is negligible.

The Threadneedle Enhanced Commodities Fund (LU0815286082) is the one viable active option available via platforms. It has been managed by David Donora and Nicolas Robin since June 2010 and buys commodity futures, but can take off-benchmark positions. The fund can also front-run the index as it re-balances, buying commodity contracts that can take advantage of price distortions created by the sizeable ETFs and index rebalancing once a year. Over three years this has not worked, with the index rising 16 per cent and the fund returning 8 per cent. However, the active positions taken could result in beating the index in future. It has an ongoing charge of 1.1 per cent.

Fund performance

Source: FE Analytics, as at 9.08.18 *Fund charges additional 0.15 per cent swap fee