Higher food and energy prices are getting a lot of attention this year and have impacted consumer budgets in the U.S. and across the world. Investors have focused on the rise in basic material costs, as well, especially in light of the declines we’ve experienced in stocks, bonds, and real estate. In fact, many commodity prices have bucked the overall trend and are showing strong gains this year. The Bloomberg Commodity Index, an index of diversified commodities, returned +21.3% in the first half of 2022, trouncing virtually all other asset classes. Given their recent performance, as well as their reputation as an effective inflation hedge, we have seen that many investors today are asking if commodities deserve a space in their portfolios.
Let’s explore that question this month, beginning with a definition of the term commodity:
Definition: A raw material or basic good, used in commerce, that can be used interchangeably with another commodity of the same type. Commodities can be “hard,” such as metals, or “soft,” as in agricultural commodities. Because they are standardized and interchangeable, they can be actively traded using futures markets for both hedging and speculation.
Examples: Energy (Oil, Natural Gas), Industrial Metals (Aluminum, Copper, Nickel), Precious Metals (Gold, Silver, Platinum), Agricultural (Corn, Soybeans, Wheat, Sugar, Coffee and Livestock).
Now that we know what commodities are, how have they performed as an investment over the long run? Again, using the Bloomberg Commodities Index (30% energy, 35% agriculture, 15% industrial metals, 20% precious metals) as our benchmark, we now have 30 solid years of returns data to help us answer that question. And the results are pretty clear – as a standalone investment, commodity performance has been lackluster at best.
Since 1992, the Bloomberg Commodities Index level has risen 18.2%. Note that is for the total period, not an annualized figure. For comparison, the CPI index of consumer inflation is up about 115% over the same timeframe. If you think about commodities having “one job,” it would be to (at least) keep up with inflation; but, for the past 30 years, we have seen that a diversified basket of commodities has failed at this task.
You can see from the chart that since around 1997, commodities have had a long and interesting trip to nowhere. Prone to huge boom and bust cycles, the volatility level of the BCI (~15% annualized) rivals that of an equity index such as the S&P 500. Commodities did have one spectacular decade, from 1998-2008, producing total returns of about 150%. However, it’s been generally downhill since then — from the top in July of 2008, commodities are now down a stunning 50% over the past 14 years.
But as evidence-based investors, we know that potential investments should be judged in the context of one’s total portfolio and not on their individual performance alone. As we’ve seen with adding other “alternative” investments like gold, low correlations with traditional stock and bond investments can sometimes be enough to improve the overall characteristics of a well-diversified portfolio.
To find out if this might also be true for commodities, I formed four portfolios with varying allocations to commodities (0%, 5%, 10%, 15%) in each. Portfolio 1 is a traditional 60% US stocks / 40% US Government Bond portfolio. Portfolios 2, 3, and 4 increase the exposure to commodities by 5% (sequentially) and reduce the weight to equities by the same amount. Performance figures are for the 28-year period from 2/28/1994 to 6/30/2022, and the portfolios were rebalanced quarterly.
The results are somewhat mixed — adding commodities to a 60/40 portfolio reduced both risk and return, but the impact on risk (standard deviation) was greater than the impact to returns. It is unsurprising that returns declined as the portfolio allocation shifted from stocks toward commodities; stock returns were much greater than commodity returns over this period. Despite the lower returns, the Sharpe Ratio, a measure of portfolio efficiency, improved slightly, reaching its maximum at a 10% weight for commodities. The maximum drawdown was also reduced modestly in the 50/40/10 commodities portfolio.
Do these results suggest that Portfolio 3 is “superior” to Portfolio 1? That argument is harder to make. Importantly, this study looks at just one 28-year period. That may seem like a long time, but it is probably not long enough to draw any firm conclusions. With that being said, the reduction in annual returns from 6.9% to 6.3% was significant after compounding. Compared to Portfolio 1, the terminal wealth of an investor in Portfolio 3 was reduced by nearly 15% after 28 years. That seems like a high price to pay to improve efficiency only marginally.
The collective experience of financial advisers suggests that for most investors, the “best” portfolio is typically the one you can stick with for the long term. If the future looks anything like the past, investing in commodities will require nerves of steel. While a small allocation to commodities may improve the risk/reward balance in some portfolios, you should expect extended drawdown periods and high volatility in that part of your portfolio. Commodity returns may not keep up with general inflation and could be a drag on overall portfolio performance. If that all sounds difficult to stomach, we believe you will probably be better off with a more traditional portfolio allocation.
