Is now the time to diversify with commodities?
''Investors who had an allocation to commodities in the early part of this decade will not be in a hurry to return. Commodity investing, which involves buying exposure to raw materials, be it minerals, metals or food, is generally used to diversify equity and bond risk. Individual commodity prices run in different cycles to those of companies and debt markets and can also be a hedge against inflation. However, a strong correlation in 2008 to equities and a severe bear market for industrial commodities, particularly energy, between 2011 and 2016 made investors think again. Since 2016, the market has rumbled on in a somewhat smoother fashion and its benefits are being recalculated.''
''What makes commodities a good diversifier is that individual commodity prices are affected by different factors. This means the factors that affect the price of wheat do not affect the price of zinc and visa versa. Thus, a basket of commodities is itself diversified and so the addition of this basket to a portfolio of equities and bonds should help as the underlying assets all march to their own beat.
To understand its impact on a portfolio, we need to look at the correlation coefficient of commodities to equities and bonds. This figure measures how one asset matches the performance of another. A figure of -1 means that as one rises, the other falls by the same amount - perfectly uncorrelated. Zero means no connection between the two, and 1 means they rise and fall perfectly in tandem.
Over 15 years, the Bloomberg Commodity index has a 0.48 correlation with global equities, measured by the MSCI All Country World index. A positive figure is expected, given that commodities and equities both tend to do well in the expansion stage of the economic cycle, but it is still a relatively low correlation, being closer to 0 than 1.
Commodities' correlation with bonds is also relevant given any allocation to commodities from a diversification perspective would likely come at the expense of bonds. Over 15 years, global bonds as measured by the Bloomberg Barclays Global Aggregate index and commodities have a 0.38 correlation.
The 15-year figures may not fill investors with absolute confidence on diversification benefits, however there are some anomalies to consider – particularly those created by the financial crisis, quantitative easing and the skewing of the bond market, and the severe bear market for commodities.
Over the shorter term, such as three years, commodities and bonds have a correlation of 0.23 and commodities and equities 0.22. Over one year, the figure for bonds and commodities falls to 0.01 – an almost perfect diversification figure. For equities, it rises to 0.44. However, this can be explained by the volatility created by trade war tensions – which affected both share and commodity prices.
It is also worth analysing how an allocation to commodities would affect a portfolio. We ran two portfolios alongside each other to see the effect. Portfolio 1 has a 60 per cent allocation to the MSCI AC World index and 40 per cent to the Bloomberg bond index. Portfolio 2 has the same 60 per cent equity allocation but 30 per cent in bonds and 10 per cent in the Bloomberg Commodity index.
Over one and three years, Portfolio 2 has provided a better return, but over five, 10 and 15 years Portfolio 1 outperformed.''