Commodities as a group, measured by the long-only indices, have a low correlation to traditional asset classes such as fixed income and equities, we would expect a diversification benefit by adding an allocation to commodities to a traditional portfolio. This diversification benefit is often cited as a key reason for making an allocation to commodities. The degree to which commodities provide a hedge against inflation depends largely on the index used to represent commodities.
While we recognize that a tactical allocation to commodities may be beneficial during inflationary periods, over the long-term most commodity prices do not keep pace with the CPI (again, energy being the key exception). For this reason, we believe commodities are better viewed on an individual basis with a focus on those commodities or areas of the commodity market that provide the greatest potential for long term gains.
The Case For Commodities
Recent gains in the commodity markets have been substantial and many are asking if now is a good time to allocate assets to this area of the market. As seen by the returns in the graph below, the major long-only commodity indices posted annualized gains approaching 20% over the past five years. Indeed, rising commodity prices seem to dominate the headlines as of late. Proponents of investing in commodities point to increased demand from emerging markets as a key factor that could drive higher long-term prices. Proponents also point to the time lag in bringing new supply of certain commodities to the market. There can be significant time required to build new oil refineries, steel production facilities and mining operations, all of which are capital-intensive investments and could contribute to supply shortages.
Other points made for investing in commodities include strong performance by financial assets over the past 20 years, driven largely by falling interest rates. While a number of factors could contribute to inflationary pressures going forward, including excessive monetary liquidity and supply/demand imbalances, most commodities, as we have seen, do not constitute a good long-term inflation hedge.
Given the recent gains in commodities, most notably energy-related commodities, it is difficult to make a case that now is a good time to take a long position in an index with a significant weighting in energy. Crude oil has increased five fold since 1998, rising from $10 a barrel to over $50 today, and continues to press toward new highs almost daily. Likewise, natural gas has more than doubled since the end of 2001.
While we recognize that there are a number of factors that could increase demand for natural resources and commodities, we also recognize that current record high prices of many commodities may not be sustainable and may present significant risk. We are also mindful that a slowdown in emerging markets could result in a slowing demand for commodities and put downward pressure on commodity prices, as emerging markets are a primary source of demand for many commodities.
Conclusions and Recommendations
We believe that individual commodities should be evaluated based on their relative attractiveness in order to fully capture the benefit of investing in this area. Based on historical data, energy-related commodities have outpaced inflation and have provided the most attractive returns while agricultural related commodities have failed to keep pace with inflation.
Our conclusion is that accessing commodities through long-only indices is not the most effective means to benefit from this area of the market. While long-only commodity indices provide a simple way to gain exposure to a cross section of the commodity market, we believe that commodities are better viewed on a sector-specific basis to determine which commodities may make compelling investments. Other vehicles, such as managed futures strategies, may be more appropriate when seeking to gain exposure to commodities.
We also recognize that macro economic trends will likely favor real assets going forward and that some commodities will benefit from increased global demand. We recommend that clients consider the available long-only alternatives to protect portfolios from rising inflation.
While commodities represent an opportunity to add exposure to an asset class with a low correlation to equity and fixed income, their ability to act as a long-term hedge against inflation remains unclear because most commodities have not kept pace with inflation over the long-term. Additionally, the diversification benefit to an already diversified portfolio that results from their low correlation to other asset classes does not appear compelling enough to warrant a strategic allocation to the long-only indices. The same diversification benefit could be achieved by adding other asset classes to a portfolio with lower volatility. Additionally, much of the returns offered by these investments come from sources other than the underlying commodities themselves. By approaching physical commodities and natural resources from a sector basis we believe investors can benefit from those areas that have the most potential for producing the greatest returns and benefits to the portfolio.
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