Diversifying With Commodities

By: S. G. Lacey

The start of each new calendar year is a great time to review one’s investment performance and portfolio construction.  As 2019 begins, there are many macro level changes occurring globally including rising interest rates, slowing economic growth, market volatility, and potentially even an uptick in inflation, something not seen in many developed countries for nearly a decade.

While stocks and bonds provide a solid foundation for any investment portfolio, with the lousy projected US returns in both of these core categories, it may make sense to explore alternative asset classes for diversification.  One potential area is commodities which represents a broad swath of key raw materials including, but not limited to, energy, metals (precious and industrial), and agriculture (grains, livestock, and softs). 

The pie charts below show a breakdown for two of the most common global commodity benchmark indexes as of 2016.  The Bloomberg version shown at left is based on a balanced distribution where no single commodity can have over a 15% weight.  In contrast, the Goldman Sacks (GSCI) approach broken down on the right tries to mimic the global annual raw material production levels, leading to a decidedly energy-heavy configuration as denoted by the blue section of over 50%.

Historically, physical commodities contracts have been traded daily on various centralized exchanges; some of the key global commodity markets are in Chicago, New York, London, Frankfurt, Mumbai, Shanghai, and Tokyo.  One needs only to reference the frozen concentrated orange juice contracts scene at the end of Trading Spaces to get an appreciation for the chaos and volatility that can accompany commodity trading. 

At their core, commodities are basic goods which are universally used worldwide, and therefore prices move based on global supply and demand, or at least the projection of these key free-market economic drivers.  As a result, a wide range of considerations like weather, geopolitical events, transportation costs, economic stability, and currency rates all factor into commodity price fluctuations.

When examining alternative asset classes for portfolio diversification, numerous academic studies have shown commodities exhibit a negative (inverse) correlation to bond returns, and only a low positive correlation to equities.  This data justifies commodities case for potential risk mitigation in a broad investment portfolio, if utilized appropriately. 

In terms of recent price movement, relative to core investment holdings like stocks (blue) and bonds (red), returns generated by a broad commodity basket (green) have significantly diverged over the past last 10 years as shown in the graph below.  While this decade long decline may seem like a red flag, every asset class moves in cycles and we may be entering the next cyclical bull market in commodities. 

As shown above, commodities have seen a substantial decline in value since the price of Brent crude oil, a major market constituent, collapsed from around $150 per barrel in the middle of 2008.  Commodities are closely tied to inflation and the strength of the US dollar, so the prolonged deflation and currency strengthening in the US has been tough on commodities which are priced in US$’s, however both of these trends have the potential to change in the next few years. 

That being said, global economies may be slowing causing demand for commodities to dry up, thus prolonging their decline for many years to come.  As a result, if you’re looking to diversify an investment portfolio, commodities offer a good option, but should be a small portion of an overall balanced asset allocation strategy.

Until recently, commodities could only be accessed through derivatives contracts, managed futures, or hedge funds.  Since commodities represent a claim on an actual physical asset, if not careful a futures trader might end up with truckload of corn delivered to their door.  However, in recent years this raw material space has been opened up to individual investors at reasonable fee structures via ETFs.  In fact, from an investing standpoint, commodities are one of the most rapidly changing areas of the ETF landscape.

Some of the better ETF offerings currently available in the broad commodity space, along with some key fund metrics, can be found in the table below.  This screen focuses on funds covering the full commodity landscape, however there are specific ETFs concentrating on almost any single commodity offering imaginable as well.

Comparing the ETFs above offers an opportunity to delve into some of the key details that dictate commodity performance as an asset class. 

Benchmark Holdings: 

There are a variety of different indices for tracking commodities globally; these vary mainly in the type of raw material holdings that comprise the benchmark.  The first two ETFs listed in the table above, COMB and COMG, are offered by the same provider, GraniteShares, and have similar, low expense ratios but track two different commodity indices: the Bloomberg and Goldman Sachs previously discussed via pie charts.  As shown, the major difference between the two benchmarks is the relative percentages of the total portfolio allocated to energy, metals, and agriculture.

Roll Yield: 

Since commodity ETFs are continuously buying monthly derivatives, the difference between the spot (current) market price and the futures contracts are important.  Two key commodity trading terms, contango and backwardation, are used to describe the difference between a commodity’s spot price and the futures contracts being offered.  As shown in the graph below, in a contango situation (red), the 1-year out futures price is higher than the projected market price, resulting in a negative roll yields as the contract approaches expiration at the steady spot price (blue).  Backwardation (green) is essentially the inverse scenario, where a lower futures price one year out results in a positive roll yield at maturity.  Some commodity ETFs, like PDBC and RJI shown in the previous fund screen table, seek to optimize the roll yield of futures contracts during monthly rebalancing; this approach can have a significant influence on realized investment returns.

https://www.investopedia.com/articles/07/contango_backwardation.asp

Momentum Factor: 

In addition to simply matching a benchmark and optimizing contract efficiency, factor-based trading approaches similar to those used for stock selection can be applied to commodities.  The most common factors utilized in commodity ETFs are momentum (based on recent price action) and value (based on backwardation levels).  A few of the ETFs listed in the table above, COM and SDCI, apply these analytic methods in an effort to enhance the commodity returns from a basic indexing approach.

Equity Options:

Besides purchasing physical commodities, another strategy is to invest in companies whose general business model is based around commodity pricing.  These companies come in various forms including raw material extractors, secondary processors, or finished commodity sellers; think drillers, refiners, and gas stations in the crude oil sector.  A few ETFs that warrant examination with this approach are GRES, which focuses on purchasing a global basket of commodity producer stocks, and COMT, which uses a combination of equities and derivatives in the commodities space.  An added benefit of this approach is that the stock holdings in the portfolio can provide a dividend yield, which is not the case for most ETFs trading only commodity futures.

Taxation:

Nearly all commodity ETFs are somewhat actively managed, using futures and options contracts rather than owning/holding the actual physical raw materials.  Originally, there was significant taxation paperwork associated with commodity trading since it involves buying and selling forward contracts as opposed to hard assets.  However, commodity ETFs that don’t require a complicated supplemental K1 tax fillings are now readily available; all the ETFs in the table above satisfy this simplified requirement.  Still, commodity ETFs are most effective when placed in a tax-deferred investment account like a 401k or IRA.

Lastly, it’s important to understand the volatility of commodities and the potential for large losses even in a generally rising stock market environment.  However, this lack of correlation is exactly why it may make sense to have a small amount of your portfolio in commodities.  If one believes the thesis about rising global inflation over the long term, a simple hedging approach is to hold a broad basket of commodities.                                                                                                                  

There is a wealth of information online about commodity history, logistics, and investing.  For those looking for additional details, the link below is as an excellent overview for learning more about what commodities are, how they are traded, and what role they should play in your portfolio. 

https://www.fool.com/investing/2018/05/16/your-guide-to-investing-in-commodities.aspx

As always, the goal of this column is to simplify investing, using fundamental terms and concepts, while still being accurate and comprehensive; don’t hesitate to reach out (sglacey@gmail.com) if you have any additional questions or thoughts. 

Invest wisely and don’t forget the power of low fee, automatic investment combined with compounding growth over time.

Disclaimer: This article is for informational purposes only; investments or strategies mentioned may not be suitable for everyone and the material does not take into account individual objectives or financial situations.  The author may own shares of some of the funds discussed.

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