Commodities Belong in a Balanced Portfolio - Never Mind the Cycle
With what some say about the end of the commodities supercycle, are commodities investment still attractive?
: We were never sold on the ‘supercycle’ concept in the first place. Mellon Capital has never tried to time supercycle movements of commodities as an asset class. Our view continues to be commodities are risk assets that, on average, rise with inflation. They also rise and fall idiosyncratically depending on supply and demand. Therefore, adding commodities to a portfolio can diversify stocks and bonds; help to hedge portfolios against rising inflation; and, if the commodities are properly managed, may even enhance portfolio returns.
We think it is important to invest in commodities through futures contracts. Commodity futures offer two independent sources of returns: “physical” returns (also called “spot” returns) and roll yields (returns from rolling short-term contracts into longer-term ones and profiting from the convergence toward a higher spot price.)
Investors should consider trying to capture both sources of returns and capturing more roll yield returns through active management. Investors can also consider capturing physical returns. Take corn as an example. In a competitive economy, the price of physical corn should converge in the long run to its marginal cost of production, or how much it costs to grow, and that cost will probably go down over time due to advances in farming technology and genetic engineering and so on. In the short run, however, corn prices can spike or fall for many event-driven reasons, such as weather or disease disrupting a corn crop or geopolitical factors discouraging imports and exports. So the price of physical corn is volatile in the short run and reverting to its production costs in the long run. This means investors may be able to benefit from short term price swings by proactively positioning portfolios to overweight commodities that appear to be in short supply or high demand, and underweight (or short) commodities that appear to be in surplus supply or low demand.
How do you expect commodities will perform in 2014?
: We see more activity in physical commodity markets. As the economy continues to recover, consumers generally demand more commodities and commodity suppliers and refiners produce more of them to sell. More physical activity leads to more hedging and trading activity in commodity futures markets as well.
We believe investors should consider actively managed commodity products to get the most out of their commodity exposure. The traditional passive long-only commodity baskets can be subject to high volatility. On a risk/reward basis, we believe properly managed commodity baskets with a risk allocation to capturing pairwise or roll yield returns are more attractive investments over time.
How much diversification can investors really gain from an allocation to commodities given how closely correlated with equities this asset class has been?
: In recent history, some people have reduced or criticised the use of commodities for diversification by pointing to their rising correlations with stocks and bonds. But we completed an unpublished study and found that while the correlation between energy commodities and industrial metals and stocks and bonds increased significantly during and after the financial crisis, this situation is alleviating. In the second half of 2013, correlations were falling and reverting back to their historically tame, range-bound levels.
We believe correlations will continue to normalise and that diversification benefits will return to pre-crisis and pre-recession levels. This is because commodity prices, in normal times, reflect ‘main street’ marketplace activities while stocks and bonds reflect appetite for financial risks and rewards. That is, stocks and bonds are financial instruments while physical commodities are real assets whose prices are driven by people buying ‘real’ items, like soybeans.
Commodities became correlated to stocks during the financial crisis because investors were reassessing their risk appetites for all risky assets and reallocating accordingly without the normal differentiation between ‘real’ and financial assets.
Commodity futures are the main liquid alternative asset class to stocks and bonds. You may achieve diversification in two ways. One way is commodity beta or ‘net long’, commonly known as ‘commodity exposure.’ On top of simple exposure, another option is the active return or ‘alpha’ that active management may deliver.
Because commodity alpha comes from commodities rather than stocks and bonds, they help to diversify the traditional alpha from stocks and bonds. In the environment we expect in 2014 and the foreseeable future, commodities could bring value-enhancing and risk, reducing diversification to a portfolio.
Will the inflation hedging role of commodities be important to investors in 2014?
We believe it’s a mistake to wait for inflation expectations to rise before allocating into inflation hedging assets. Markets are an expectations game and asset prices frequently move with market expectations. If you are waiting for inflation to hit before allocating to commodities or real assets, the markets may already be moving against you by the time you start to do it.:
In our view, it’s wise to look into it now whether or not you believe 2014 will be the year inflation starts. In the longer term, we expect there could be a lot of inflation simply because the growth in money supply has gotten ahead of GDP growth in the US and other developed economies. It’s hard to time precisely when inflation will hit, so why risk it? Precisely because timing is hard, we think investors should consider allocating to inflation hedging assets, like a basket of properly managed commodity futures.This is not investment advice. Regulatory Disclosure