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Stephanie Flanders: Asset class that came in from the cold

After falling 30 per cent between 2010 and 2013, commodities are on their way up and, as part of a diversified portfolio, are worth looking at again

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Commodities have not been a popular asset class among investors in recent years – for good reason. The Bloomberg/UBS Commodity Index fell by 30 per cent between 2010 and 2013 as the slowdown in the global economy sapped demand.

But in the first half of 2014 the same index has surprised most analysts by rising 7.1 per cent – the best start to a year since 2008. It is too soon to call the bottom of the commodity cycle, but with the global economy on the mend, investors should be taking a fresh look at commodities and the benefits they offer.

Advantages of commodities

The traditional case for investing in commodities can be summed up with DIG: diversification, inflation orientation and global growth.

Commodities are diversifying because individual commodity prices are typically affected by factors that are not highly correlated with each other or with other markets. In the 30 years from 1973 to 2013, the correlation of the Bloomberg/UBS Commodity Index with global equities was just 0.12 and was slightly negative with sovereign and corporate bonds.

The diversification benefits more or less evaporated in the aftermath of the financial crisis – correlations rose to almost one in November 2010 and stayed above 0.50 until mid-2013. In times of extreme market stress nearly all asset classes move together, but these periods are few and far between and correlations have fallen back to historical averages. This on its own may be a good reason for investors to move to at least a neutral weighting for commodities within their portfolios.

Given recent events, it is worth noting commodities have often been particularly beneficial in protecting portfolios during periods of geopolitical stress. A recent survey of risk perceptions among investors found geopolitical risk is now ranked equal with central bank policy as the key driver of market risk. Commodities often outperform equities in periods of extended political unrest; equity prices often go down in these environments, but commodity prices will often go up because of worries about disruptions in the supply and transport of those goods.

Inflation has not been a big concern for investors in recent years – in the eurozone, especially, the focus is more on the threat of deflation. But inflation is likely to reappear at some point if the global recovery continues to gain pace – and may come sooner than many expect in the US.

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Historically, when inflation is rising from a low base, commodities tend to outperform other assets such as real estate and government bonds, rising on average 17 per cent. There may be little sign of inflation on the horizon in most countries, but the purpose of a diversified portfolio is to protect against the unexpected. In this context a core exposure to commodities seems a useful insurance policy, in a world in which few investors are positioned with the threat of inflation in mind.

The final benefit of commodity investment is exposure to global growth – the growth of emerging markets in particular. The developed world used to be the price makers in global commodity markets and developing countries were the price takers. But that changed from the 1990s, as fast-growing emerging market economies began to drive global demand for these goods. 

Investing in commodities is not the only, or even the best, way to gain exposure to that growth – but it is the only one that also diversifies and protects against inflation.

Accessing commodities

You might wonder, given all these purported benefits, why commodities have had such a rough ride. The answer is volatility. This can play havoc with a portfolio and is due to ever-changing levels of supply and demand in the commodities market, which even commodity specialists find extremely difficult to model or forecast reliably. In the face of these complexities, many investors take the understandable decision to steer clear of them altogether.

There is, however, a well-established solution to this problem  which should allow investors to have their commodity cake and eat it too. That is to invest in equities that are highly correlated with commodity prices, but which are much less volatile.

Investors have been appropriately downbeat about investing in commodities, given their poor performance. But the relatively strong performance of commodities in the first half of 2014 underscores that some of the traditional benefits of investing in commodities may now be reasserting themselves. The time for at least a neutral exposure to commodities in a diversified portfolio has probably arrived.

Stephanie Flanders is chief market strategist for Europe at J P Morgan Asset Management

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  1. Dear Ms Flanders,

    Useful comment but buying equities that are highly correlated with commodities undermines your argument for using commodities to diversify the portfolio as you would be increasing the beta exposure and increasing the exposure to an asset class with negative skew. Please provide evidence as to how adding to commodities related equities would have insulated the volatility of a portfolio? Do such equities have lower betas?

    The other drawback is that the graph used in this article uses the Goldman Sachs index which has a high exposure to energy (about 67% +) and so unsurprising that it does so well when risks involving oil producing regions arise; what about other types of crises not related to oil producing regions? The GSCI is not as diversified as other indices and so it further undermines your diversification view. Better to use a broader based commodity index to moderate the influence of energy weighting.

    For most investors the exposure to commodities is via futures contracts and so you neglect to mention the importance of the sources of that return e.g roll yield (negative or positive); contango and backwardation; also since commodities are priced in US dollars the chart makes sense if you are a US$ investor but for a sterling investor any US$ gains could be offset by GBP strength.

    Finally the article sadly like most of its type in this publication suffers from performance myopia ie no mention of costs and risk-adjusted returns. Investors care about the returns one can eat (ie after costs etc) and that take into account the risks involved.

    For further information please see my ‘Amnesia Antidote’ http://www.unbiased.co.uk/news/Amnesia-antidote:-what%E2%80%99s-the-difference-between-client-and-investment-performance%3F/2063

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