Remember when a strategic investment to commodities was pitched as the ultimate portfolio diversifier: low correlations and equity-like returns? We sure do. Back in 2006 near the outset of this blog we wrote about the topic and asked:
“Facts and Fantasies about Commodity Futures” by Gary Gorton and K. Geert Rouwenhorst found substantial evidence for the inclusion of commodities in an portfolio. They found collateralized commodity futures have had similar returns to equities while being negatively correlated with equity and bond returns. In addition they found commodity returns to be positively associated with concurrent and unexpected inflation.
This is indeed nirvana for asset allocators – equity-like returns from a portfolio diversifier. While there is some dissent from their conclusion among academics, their research was picked up by multiple media sources as a major discovery. The question for investors is whether their results, and subsequent investor behavior have changed the investment equation for commodity investment?
New “discoveries” in the financial markets are indeed rare. We re-visited the topic a few years ago as evidence piled up that the rush of individual and institutional money into the commodities markets had changed the underlying dynamics of the commodities markets:
Where does this leave investors facing the questions of asset allocation in a more volatile age? In short, commodities are not a one-way bet. A passive approach to commodities investment glosses over the complexities of actual commodity investment. The headwind of a broad variety of commodities in contango makes an index-like bet problematic at best.
Now that gold has cracked and the commodity superbull is over it now seems that the new default is that strategic commodities investments are not a suitable part of an asset allocation program. Mark Haefele writing at FT Alphaville notes all the reasons why commodities no longer work:
Investors have long looked to commodities to answer specific needs in their portfolios. But we find it hard to justify any long-haul allocation to the asset class. Over the next five years, our financial models show that commodities will generate equity-like volatility of about 18% on average with returns of under 2 per cent a year. According to our medium-term outlook, this gives commodities an expected risk-adjusted return that is inferior to all other asset classes. Although investors can still generate gains by investing in commodities on a tactical basis, we feel the benefits of strategic holdings in the asset class have waned to the point of non-existence.
Undoubtedly the ETF-ization of everything played a role in the rise (and fall) of commodities. But in the end it was good old fashioned greed and herd-like behavior that took a hint of an anomaly and blew it up into a full-fledged commodity bull market. Once the dynamics of the commodities market changed and it was obvious the benefits of a commodities allocation was oversold money flowed back out. So here we stand after a round-trip in thinking on commodities. The question is what next?