Wednesday, October 20, 2010

Do Commodities Have a Place in Your Portfolio?

Most investors are well diversified within the equity asset class, both domestically and globally. Once diversified, trying to reduce risk further will have little impact as individual stocks, the different equity markets, and investment styles are highly correlated with each other. Moreover, correlations has been increasing in the last few years. Bonds traditionally have been used to diversify, but with record low rates, the prospects for decent returns are poor.

In order to reap the benefits of diversification, the investor needs to add non-correlated assets to  their portfolio.  The use of commodities can offer this improved diversification to an investor's portfolio. Commodities, like oil, gold, copper, wheat or cattle are impacted by factors considerably different from those that influence stock and bond returns and volatility. This makes commodities intrinsically different from stocks and bonds, resulting in a low correlation.

The prices of commodities respond more to current supply–demand conditions, whereas the prices of equities and bonds, respond more closely to the longer-term outlook. Commodities will react to events that in most cases are not related to the underlying economy. As an example a poor harvest of corn in the U.S can have signification price ramifications not only to corn but other agricultural products as well. We have all seen what happens to the gold price in time of any international crisis.

In addition, commodities can hedge against unanticipated global growth. As emerging countries  move up the development chain they consume commodities more intensely on a per capita basis, placing upwards pressure prices of those commodities.
 Risk Return Profile of Adding Commodities

Not only do commodities have low correlations with traditional asset classes and the overall business cycle but correlations are also low between the different commodity sectors. Historical data indicate that their long term have been similar to those on equities, and the volatility of commodities is only modestly higher than that of equities. But when commodities are combined with a traditional portfolio the overall risk is reduced.

Another option of investors is to buy the  common shares of companies that produce commodities as a proxy for the underlying commodity. As an example an investor can buy energy stocks instead of oil. The problem with this strategy is that the return is affected by factors other than the commodity’s price. The investor is buying the management talent and financial structure of the companies, but management, based on sound reasoning, may decide to hedge production, limiting the upside move in commodity prices. Generally returns on the stocks of commodity producers are not as highly correlated with the returns on the commodity as they are with the returns on the stock market as a whole.  In other words, commodity-related stocks behave more like other stocks than their underlying commodity.

Until recently, commodity exposure was usually  through commodity futures making it out of reach to all but the most sophisticated investors and institutional traders. These barriers are eliminated for the investor with the advent of diversified commodity fund and exchange traded funds and exchange traed notes. 

There is no question that adding commodities, will improve the diversification of a portfolio. More over the arrival of ETFs and ETNs make it easy for an investor to gain broad commodity exposure. However, if using ETFs fully understand, how they are constructed and ensure they are used properly in your portfolio. 

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