Investment
Negatively Correlated Commodities Reduce Portfolio Volatility
The role of commodities in a well designed portfolio is a much discussed topic among financial researchers and observers. This topic has gained increasing visibility recently as inflation concerns continue to receive media attention and stock market downturns aroused anxiety among some investors. The purpose of this article is to cut through the media and research noise and focus on the most important aspect of commodities for the design of diversified portfolios.
The generally accepted view is that commodities can provide a hedge against inflation and improve portfolio diversification. Dr. Jeremy Siegel, professor of Finance at University of Pennsylvania's Wharton School, has examined the long-term performance of gold and other precious metals. He found that investors in these commodities earned a return slightly better than the inflation rate. Dr. Siegel noted that commodities earned price appreciation over the long term, which is the only source of return for this commodity group. This point addresses the "inflation hedge" role of commodities in portfolios. However, it is important to mention that the return earned by commodities, as an asset class, comes with considerable price volatility.
Stocks, on the other hand, earned returns over the long term from price appreciation and dividends, which is why stocks have fared better than commodities over the long term for investors. Dr. Siegel concluded that it is better in the long run to own stocks in companies that are in the commodity business than the commodity directly, primarily because of the "dividend advantage" of owning stock. Owning mutual funds that hold stock of commodity companies goes one step further in reducing risk while maintaining the dividend advantage compared to owning individual stocks of companies that provide commodities.
Some commodities generate returns through differences in prices for contracts specifying future delivery or immediate delivery. When spot prices (for immediate delivery) are higher than futures prices, an investor has a better than even chance of earning a positive return on a futures contract that is held until a date close to the delivery date. The positive returns are sometimes similar in nature to premiums that insurance companies collect in exchange for reducing the risks faced by policyholders.
Given the innate volatility of both stocks and commodities, what information is useful to consider with respect to these two asset classes when designing well diversified portfolios? This question was addressed in a 2006 research paper, published by Ibbotson Associates.
The paper provides great insight into the role of commodities as a portfolio diversifier. In the paper historical returns of various asset classes from the period 1970-2004 were reviewed. During this 35-year period, there were eight years of negative U.S. stock returns. During those eight years, average annual returns for U.S. stocks were -12.28%. During those same eight years, commodities had an average annual return of +19.02%.
In financial analyst parlance, the asset classes of U.S. stock and commodities were negatively correlated during these eight years. In other words, when U.S. stocks were down, commodities were up. Negatively correlated assets allow a portfolio to have lower overall volatility, which is a valuable benefit of diversification.
We conclude that the role of commodities in portfolio design is to reduce short-term volatility and improve long-term performance for investors who have the "stomach" to deal with significant short-term commodity price swings. If commodities are appropriate for a particular client's needs, we typically recommend modest sized holdings in commodity mutual funds to gain the advantages of owning commodities while avoiding the risks of owning individual stocks of commodity-producing companies.