A broad-based commodities index as represented by the Bloomberg Commodity Total Return Index will help diversify an investment portfolio made up of both stocks and bonds but will not necessarily improve returns in the same portfolio over the long run.
The Bloomberg Commodity Total Return Index is a broad-based index of 24 commodities. The heaviest weighted commodities in the index include natural gas at 10.8%, gold at 9.8% and oil at 9.7%. The index also includes such commodities as sugar, coffee, zinc and tin. Over time, the index has returned only slightly better than inflation. From January 1992 through December 2016, the annualized return of the index was a mere 2.6% while the consumer price index (CPI) averaged 2.3% over the same time period. Likewise, the volatility of the commodity index as measured by standard deviation was 15 compared to the volatility of the S&P 500 Index at 14.2 and bonds as represented by the Barclays US Aggregate Bond Index at 3.6. However, there was a huge return differential between the S&P 500 and the commodity index during this time period; the S&P 500 recorded an annualized return of 9.1% versus 2.6% for commodities. Bonds over the same time period had an annualized return of 5.6%.
So how is it possible to add an asset class (commodities) to a two-asset class portfolio that, by itself, has higher volatility than either of the other two assets in the portfolio? The reason is correlation. Correlation is the measurement of the movement of one investment to another. A correlation of 1, means the two assets are perfectly correlated and will move up and down exactly together. A correlation of -1 means the two assets are perfectly negatively correlated. The movement of one asset in one direction will see the other asset move exactly by the same proportion in the other direction. There are very few assets that are either perfectly positively or negatively correlated. Most correlations between assets fall somewhere between -1 and +1.
The correlation between stocks and commodities is .31 while the correlation of bonds to commodities is .05. The correlation of bonds to stocks is .04. These correlations were measured between January 1992 and December 2016. When one pairs two assets together with a similar standard deviation which have a low correlation to one another, the combined standard deviation is reduced. A correlation of .31, .05 and .04 are all considered very low correlations. A high correlation would be two assets correlated at .75 or higher.
Within a portfolio made up of 60% stocks and 40% bonds, the annualized return between January 1992 and December 2016 was 8.2% with a standard deviation of 8.6. When one includes a 10% weighting to commodities and adjust the stock weighting to 55% and bond weighting to 35% (with annual rebalancing), the annualized return is 7.8% with a standard deviation of 8.4. Standard deviation or risk does decline but so does annualized return. When one calculates the risk adjusted return or Sharpe Ratio (the methodology of the Sharpe Ratio is beyond the scope of this article), one finds that the risk adjusted return actually declines when adding commodities to the portfolio. In contrast, when one adds bonds to an all stock portfolio, the risk adjusted return improves dramatically justifying a portfolio consisting of stocks and bonds versus an all stock portfolio.
One can certainly observe shorter time periods where commodities have performed very well. For example, from January 1992 through October 1997, commodities posted an annualized return of 10.3% versus stocks at 17.4%, bonds at 7.4% and inflation at 2.8%. From January 2000 through June 2008 commodities registered an annualized return of 15.1% versus stocks at 0%, bonds at 6.2% and inflation at 3.1%. One can also identify periods where commodities performed very poorly. From June 2008 through December 2016, commodities had an annualized total return of -9.7% versus stocks at 8.0%, bonds at 4.1% and inflation at 1.3%.
From the perspective of a long-term investor, it does not appear that the inclusion of commodities to a portfolio will provide measurable benefits. It is also very difficult to consistently identify periods of time when it may be more beneficial to own commodities and thus include them in one’s portfolio. It is better to stick to a long-term strategy.
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