Markets & regions: How commodities strategies can help investors diversify their portfolios
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The search is on. In the current market environment, investors are looking for asset classes that can lower overall portfolio volatility without sacrificing returns. As a result, many investment managers are working on a variety of diversification solutions and if there is one concept that encapsulates the goal of investment managers in this regard, it would be a low correlation to other mainstream asset classes. However, when looking to lower portfolio volatility, it’s important to weigh costs and transparency against any potential benefits gained. In our view, one of the simplest, yet most effective ways to potentially reduce portfolio volatility is through the use of commodities.
Commodities – the logical way to diversify
When reviewing asset class correlations over nearly 20 years (from 31 December 1998 to 31 August 2018), both the -Bloomberg Barclays US Aggregate and the Bloomberg Barclays Global Aggregate Bond indices have exhibited low correlations, and in some cases, negative correlations to equities. However, the correlation of these two indices to each other has been medium to high, measured at 0.71, suggesting that US bonds and global bonds do not offer much in the way of diversification from each other. Intuitively, this makes sense, as global interest rates do exhibit relationships to one another.
In contrast, although the Bloomberg Commodity index did not exhibit the lowest correlation to any of the other assets, its highest correlation with any other asset class was 0.52, and this was to the returns of the MSCI Emerging Markets index. This suggests that commodities, overall, have generally offered low correlations to a mix of different global asset classes in the past and are therefore capable of providing investors with valuable diversification benefits.
Equities are considered by investors to be ‘risky’ assets. This perception translates into certain behaviours – most notably that when investors feel positive about markets, global growth and corporate earnings, money tends to flow toward equities.
Conversely, when sentiment turns negative, money flows out of equities. As it has become easier in recent years for investors to invest globally, correlations between regional equity markets have increased.
Certain large global bond markets such as US Treasuries, German Bunds and Japanese government bonds are considered to be ‘risk-off’ assets. While returns are generally not high, there is a perception that these markets offer near risk-free returns, with a high probability that capital will be returned at maturity and interest will be paid as scheduled.
As a result, when investors become concerned about equity markets, they often sell equities to buy these assets, and this accounts for the historical negative correlation between equities and these bond markets. Given that the US, Germany and Japan are some of the largest debt issuers in the world, the behaviour of these markets tends to dominate the behaviour of global bond indices, such as the Bloomberg Barclays Global Aggregate Bond index.
Yet, commodities are perceived differently by investors as the asset class behaves in a unique way. Fundamentally speaking:
• When the demand for a particular commodity is greater than the supply, the price of that commodity will rise.
• When the supply of a particular commodity is greater than the demand, the price of that commodity will fall.
For this reason, commodities as an asset class can provide investors with diversification benefits as returns from commodities often have a low correlation to the returns of equities and bonds.
Commodity price movements and futures
While the concept that commodities have a low correlation to other assets makes sense, any investor interested in including commodities within a portfolio needs to consider at least one further issue and that is how exposure to commodity price movements is to be best achieved.
When it comes to certain commodities, such as gold or silver, buying physical commodities is an option. However, not all commodities are as easily stored as precious metals. As such, many investors turn to futures contracts for exposure to commodity price movements, as with futures there is no need to physically hold and store each commodity. Yet do futures capture commodity price movements effectively? Let’s examine the case for oil.
Frequently, investors think of a commodity like oil and see the price portrayed through popular platforms and news outlets. The performance of this observable price is what they aim to capture.
However, the total return associated with oil involves rolling one futures contract to the next, incorporating a concept known as roll yield. Roll yield is the impact on performance that comes from needing to roll one futures contract to the next each time a contract expires. In 2017, we saw ‘contango’ in the oil market where each successive futures contract was indicating a higher price for oil, leading to a negative roll yield and a total return that lagged the spot price. In contrast, in 2018, we saw ‘backwardation’ in the oil market where each successive futures contract was indicating a lower price for oil, leading to a positive roll yield and a total return that outperformed the spot price.
Therefore, instead of rolling one futures contract to the next in the same manner at set intervals, we would advocate considering approaches to broad commodities that account for backwardation and contango, to help achieve the diversification benefits that commodities can provide, without the negative impact of contango, if it occurs.
Diversify with a broad basket of commodities
Perhaps the best way for investors to diversify their portfolios with commodities, in our view, is through an exchange-traded product (ETP) that tracks a broad diversified basket of commodities, such as the Bloomberg Commodity index. Consider that:
• Many see gold, a precious metal, as insurance against the loss of purchasing power of global currencies.
• Many see oil as the fuel for economic growth. As growth increases, it is reasonable to expect demand for oil to increase, pushing prices higher. On the other hand, higher oil prices inspire further exploration and production of more oil, which increases supply.
• Wheat is important in feeding the global population. While it would be logical to relate demand for wheat to economic and population growth, supply is more related to weather and growing conditions in major producers around the world.
While individual commodities within different broader commodity groups in the Bloomberg Commodity index are likely to be correlated to each other, there is no reason to think that the groups should be highly correlated.
Commodities, as an asset class, have a relatively low correlation to both equities and bonds, and as a result, can help investors lower overall portfolio volatility. We believe the best way to add commodities to a portfolio is through a broad index that includes exposure to different commodities, including precious metals, industrial metals, energy-related commodities and agricultural commodities, to capture the full diversification benefits of the asset class.
Christopher Gannatti is head of research, Europe, at WisdomTree