With interest rates set to finally, if slowly, move higher and Trump’s pro-growth policies expected to cause pick-up in inflation, many investors are starting to look at adding commodities back into their portfolios. But after the commodity “super cycle” of 2004-2008 came crashing down commodities have mostly been a drag on investor returns.
But given the new environment and for those taking a long term view the question is – Do commodities enhance a typical stock/bond portfolio?
That depends on a) who you ask, b) when you ask them, c) how you define “enhance,” and d) how you define “commodities.”
In 2005, Gorton and Rouwenhorst found that an equally-weighted index of commodity futures (from July 1959 to December 2004) had historically produced the “same return and Sharpe ratio as equities” while being “negatively correlated with equity returns and bond returns.” Armed with these findings, they asserted “commodity futures are an attractive asset class to diversify traditional portfolios of stocks and bonds.”
Not long after this study, in February 2006, the first broad-based commodity ETF was launched. The PowerShares DB Commodity Index Tracking Fund (DBC) designed for “investors who want a cost-effective and convenient way to invest in commodity futures.
The DBC ETF invests in futures contracts of 14 of the most heavily traded and important physical commodities in the world.
Let’s say an investment advisor decided, after the launch of this commodities ETF, to shift their asset mix from 60/40 (U.S. Stocks/U.S. Bonds) to 50/30/20 (U.S. Stocks/U.S. Bonds/Commodities). How would they have fared?
Initially, quite good.
From March 2006 through June 2008, Commodities (DBC) gained 101.8% versus a gain of 12.0% for Bonds (AGG, Aggregate US Bond ETF) and 4.6% for U.S. Stocks (SPY, S&P 500 ETF).
A diversified portfolio including commodities over this period had an annualized return of 9.3% with volatility of 5.5%, comparing favorably to the 3.3% annualized return with 6.4% volatility for the stock/bond portfolio. The theoretical research suggesting commodities were additive to a stock/bond portfolio was playing out in real life.
And then it stopped. Crude Oil crashed in the back half of 2008, suffered another crash from 2014-2016, and Commodities never recovered. All of the diversification benefits from 2006-2008 disappeared and then some.
In the full period from March 2006 through December 2016, Commodities (DBC) lost 27.5% versus a gain of 118.4% for U.S. Stocks (SPY) and 56% for U.S. Bonds (AGG). To make matters worse, they suffered those losses with significantly higher volatility (20%) and a relatively high (0.50) correlation to U.S. equities.
The result: a diversified portfolio which included commodities during this full period gained 4.8% with 10.1% volatility versus a gain of 6.4% and volatility of 9.2% for the stock/bond portfolio. Instead of diversification, investors got diworsification.
What went wrong?
- Increased participation in and financialization of commodities may have led to higher correlations to equities and to each other.
- Those correlations reduced portfolio returns derived from “mean reversion profits, where investors were previously benefitting from rebalancing.
- Financialization also led to declines in roll yields with lower expected returns..
- Lower U.S. Treasury bill returns have reduced collateral returns.
- More long-only money reduced the premium speculators were receiving from hedging.
Case closed? Maybe not.
Theory vs. Practice
There is a lot to digest here and no definitive answers for investors. Even if we assume that commodities are additive (good diversifiers) over the long, long term (1877), the hurdle in adding them to a portfolio today is high for three reasons: 1) the lack of education most investors have when it comes to commodities, 2) recent commodity returns/volatility, 3) the higher costs associated with commodity ETF products (DBC has a total expense ratio of 0.89%).
As I wrote in my last post on factors, investors don’t hold onto things they don’t understand. At the first sign of hardship, they bail. Commodity futures are much more complicated animals than stocks/bonds and investors will have a harder time holding onto them when times are bad.
Assuming you can get over that hurdle, the higher one today is recent performance/volatility. Investors chase past returns/volatility. By past, I mean recent past (3 years or less). Investors were very receptive to commodities in June 2008 because they had strong recent performance and were compensated for taking on volatility. Since then, they have not.
Convincing investors that commodities will help their portfolio without recent returns backing that up is an almost impossible task. And in the new world order of low cost, passive investing, an expense ratio of 0.89% simply does not make the cut.
If commodities go on a multi-year rally from here while stock/bond returns are subpar, that conversation would change as investors would have their “proof” and would pay up for higher past returns. But by that time it might be too late for investors to actually benefit from adding them.
In the end, there is theory and there is practice. In practice, few investors will choose to add commodities to a diversified portfolio until commodity returns significantly improve. Is that an active decision?
Sure it is but the real question is whether it is a good decision or a bad one. Since the advent of broad-based commodity ETFs in 2006, it has been a good one. In the long, long term, the jury is still out.
— The Option Specialist