The current market turbulence and uncertainty is reaching critical levels. High inflation rates have renewed the interest in adding commodities as an alternative investment to hedge against inflation risk, increase portfolio diversification and provide additional return potential.
- The first sustained period of inflation for decades has put commodity exposure in investors’ minds as commodities are associated with inflation hedging.
- Studies also show that an increased allocation to commodities provides high returns when stock and bond returns are at their weakest.
- We explore the benefits of exposure to commodity futures, exchange–traded funds (ETFs), and commodity indices.
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The current market turbulence and uncertainty has reached critical levels.
War is back in Europe, supply chains have not fully recovered from the COVID-19 pandemic, the monetary policy makes it into the evening news, and inflation keeps rising after years of historical low values.
Given their weak performance over the past years, investors does not always include commodities in their strategic asset allocations. From an investor’s point of view, the relative performance of commodities is low compared with other asset classes, such as equities and the S&P500.
Looking at the Refinitiv/CC CRB Excess Return Index versus the S&P500 ratio, commodities have continued to fall since 2008 compared with stocks.
However, current high inflation rates have renewed the interest in commodities. Investors could use them as an alternative investment to hedge against inflation risk, increase portfolio diversification and provide additional return potential.
Data from recent studies show that an increased allocation to commodities provides high returns when stock and bond returns are at their weakest, and that it hedges against increases in inflation.
The latter should not be a surprise.
Looking at the components of the consumer price indices (CPIs), the measure of the evolving cost paid by consumers for a basket of goods and services, most of the weight is usually on real assets.
As an example, in the U.S.over 70 percent of the inflation basket is based on real assets. It makes sense, therefore, to recalibrate portfolios and increase the allocation of commodities.
How do you get commodities exposure?
Commodities have a physical dimension, and having direct ownership of a tanker of crude oil or a herd of live cattle is challenging and impractical.
For this reason, most investors tend to get commodity long exposure by investing in commodities-related stocks, derivatives, ETFs, indices, or in other indirect ways such as trade finance.
Adding shares of companies that produce, transform and trade commodities is probably the least compelling option because it adds idiosyncratic risk. As an example, labour unrest in Chile would push the price of copper higher but would negatively impact the share price of mining companies.
It would also expose the portfolio to a variety of risks at a company level, such as sanction risk, potential slavery and forced labour in the supply chain, and similar unwanted risks.
On the other hand, derivatives probably offer the best approach for institutional investors interested in getting commodities exposure.
For example, investors would benefit from a short-term tactical allocation in individual commodity futures to leverage a temporary imbalance of supply and demand.
For a more strategic and long-term asset allocation, portfolios would probably benefit the most from commodity ETFs and commodity indices as they offer a broad and more diversified exposure.
Commodity ETFs offer liquid and cost-effective access to a broad basket of commodities. They come in an array of options, each offering different advantages, drawbacks, and levels of risk.
The Lyxor CRB commodities ETF <CRB.PA>, as an example, is one of the oldest and most popular broad-based commodity ETFs available.
Interestingly, even though ETF’s inflows typically follow swings in commodity performance, the level of current AUM is considerably higher than in similar periods in the past.
Commodity indices track a basket of commodities and are an important barometer of broad trends in commodity markets.
Earlier versions were not investable as they were tracking spot prices. Over the years, however, commodity indices have evolved and represent an interesting option for investors wishing to gain exposure to a wide spectrum of commodities.
As an example, the Refinitiv/CC CRB Excess Return <.TRCCRB> Index, initially introduced in 1957, tracks the futures price of 19 different energy, agriculture, metals, and livestock exchange-traded futures.
The index is periodically revised to reflect the evolving landscape of the commodities market.
The underlying commodity futures are organised into four groups. Energy is the group with the highest weight at 39 percent, followed by agriculture at 34 percent, metals at 20 percent, and livestock at 7 percent.
To allow for a higher exposure to specific groups of commodities, there are also several sub-indices, including non-agriculture and non-energy versions.
Overlooked ESG angle
Investing in a commodity index and its underlying futures presents an interesting ESG angle that is often overlooked.
Owning shares or bonds of a company that produces or transforms commodities translates into directly financing the production or refining of that commodity. And – as at any point in time – a company’s capital is finite, so this capital can be directly linked to the carbon footprint of the company.
However, as only a fraction of commodity futures are physically delivered at expiry and as futures do not affect consumption or production of the underlying commodity, it has been argued that commodity futures offer a zero environmental impact exposure to commodities.
Megatrends transforming commodities
Investors approaching commodities for the first time must be aware of two megatrends that are rapidly transforming this exciting but complex asset class.
The first is a rapid digitalisation bringing transparency to an industry that until very recently was particularly opaque. This trend has levelled the playing field and is challenging the traditional competitive advantage of the big commodities players.
The second and possibly even more significant tectonic shift is the impact of the transition from fossil fuels to renewables. This path to net-zero emissions is radically changing the commodities landscape well beyond the energy complex.
Having access to best-in-class research, analytics, news, and the ability to commingle different sources of data will dramatically increase the chances of success for investors looking to diversify their portfolio and add commodities to their strategic asset allocation.
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