Demystifying Commodities and the Role They Play in a Diversified Portfolio

Martin Landry, CFA, CFP®, CAIA, CIMA®, CIPM, CTFA, AIF®, Senior Portfolio Manager, Investment Management Resource Group
July 2, 2019

Commodities play a vital role in the global economy. While different from more widely known assets classes like stocks and bonds, they continue to be an important holding for investors. But for many, commodities – what they are, where and how they trade and their influence on the price of goods – remain a mystery.

What are commodities?

Broadly defined, commodities are the raw materials used by both producers of goods and consumers. They include crude oil, copper, gold, sugar, corn and live cattle.

Global commodity prices are never static but will move as supply and demand dynamics shift. Changes in commodity prices can be significant and will have a direct impact on consumers as the goods and services derived from those commodities, such as corn and wheat, can often rise or fall quite significantly in a relatively short period. Additionally, changes in commodity prices along the supply chain can affect the cost of goods at the end of the chain. For example, an increase in oil prices would likely lead to an increase in the cost of transporting goods, which would then result in a price increase to consumers of a broad range of products.

How are commodities traded?

Commodities are traded as futures contracts on exchanges, and as such, the purchase of a contract does not represent an actual ownership of a physical commodity. In this respect they are different from stocks or bonds. They are not claims on long-lived corporations, they do not raise resources for firms to invest (i.e., capital) and they cannot be valued as a series of discounted cash flows. There is not a “coupon to clip” like a bond.

Investors should understand that commodity futures contracts are derivative products. They represent indirect exposure to physical commodities. Commodity futures prices are the result of supply and demand fundamentals, storage costs, transportation costs and the logistical issues of rolling contracts by index investors. Simply put, futures represent bets on the expected future spot price at some point in time in the future.

What do investors need to know about the commodities market?

While the commodity asset class has been quite volatile over the last several years, there are valid reasons for its continued inclusion in a diversified, multi-asset class portfolio. The pattern and variance of returns for commodity futures is sufficiently different from that of stocks and bonds, and the correlations with the other major asset classes range from a low of near 0.1 to a high around 0.6. Commodity futures appear to be a natural diversifier to investment-grade fixed-income securities.

However, investors should realize that global economic integration, the growing influence of China in commodity consumption and new financial products that emphasize commodities, appear to have fundamentally changed historical relationships between equities and commodities. In addition, it is important for U.S.-based investors to understand that many commodities are international in nature, and the effect of changing relative (U.S.) dollar value to other currencies can affect demand for commodities and thus the price. Commodity markets are in a constant state of evolution, and there are times when futures-based commodities may not have a positive expected return. However, most of the historical high returns of commodities came from the high returns from the fixed income collateral that underlay investments in commodity futures and from the positive roll yield from rolling an expiring contract into a lower priced next month contract (i.e., backwardation).

When is the best time to own commodities?

In general, the best time to own commodities is during periods of unexpected high inflation. This is usually driven by a scarcity of supply (cost-push inflation) or unexpected growth in the demand for a commodity (demand-pull inflation).

Over the last 10 years, the nature of the types of investment vehicles available to retail investors to invest in commodity futures has changed. The number of open-end mutual funds, exchange-traded funds (ETFs) and exchange-traded notes (ETNs) attempting to capture the returns of a basket of commodities futures has risen, and with this increase has come a shift in investor preferences of the underlying benchmark against which most of these mutual funds are indexed. Currently, most open-end commodity mutual funds are benchmarked to the Bloomberg Commodity Index Total Return.

The questions above are a great start to understanding the mystery of commodities. As you learn more about the impact commodities have on so many other areas of the financial world and our economies, their value as a holding can be better appreciated.

References:

Postmodern Investment: Facts and Fallacies of Growing Wealth in a Multi-Asset World, Garry B. Crowder, Thomas Schneeweis, Hossein Kazemi, Wiley Finance Publishing, Hoboken, New Jersey, 2013.

The Handbook of Inflation Hedging Investments: Enhance Performance and Protect Your Portfolio from Inflation Risk, Robert J. Greer, McGraw Hill Publishing, New York, New York, 2006

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