Commodity futures offer investors access to unique exposures that can diversify against specific risks in a portfolio.
Most retail investors are either Diversification provided by raw materials or knowingly but incorrectly invested in raw materials.
This can actually result in a portfolio with more risk.
This article provides some considerations for using commodities judiciously to diversify a portfolio.
A casual investor looking to diversify their portfolio into commodities may find themselves a little confused over the past few years.
The portfolio they thought was diversified does not appear to be diversified at all.
Below is a graph showing the S&P 500 (in orange) and DBC, an ETN tracking commodity (in red). We can immediately see that they are very correlated.
Simply adding commodities to a stock portfolio didn’t help at all during the 2018 or 2020 downturns.
Indeed during the Bear markets above the commodities portfolio fared behind the S&P 500! This diversification turned into despair!
In fact, you would have less risk if you short the commodities while going long on the index. So what happened here?
A first important thing is that not all bear markets are created equal.
They happen for a unique reason.
The 2008 recession (which also saw commodities declining) was triggered by the subprime mortgage crisis. 2020 was caused by the coronavirus pandemic.
These crises have been accompanied by a slowdown in economic activity, which is necessary for the demand for most raw materials.
As a result, investments in commodities and stocks have not done well over these periods. So when do raw materials perform better?
The only best hedge commodities are against inflation.
Below you can see the performance of various raw materials as consumer prices rise.
Inflation is defined as the increase in consumer prices over time.
Since raw materials have a direct impact on consumer prices, an increase in raw material prices naturally leads to an increase in consumer prices.
This is no more common than with oil.
Rising oil prices affect the entire macroeconomic chain, from the prices of the food we eat to the trips we take.
So oil is, of course, one of the best inflation hedges.
In many developing countries, such as Venezuela, citizens know all too well about inflation.
To the rest of us, it seems like a headline that never really mattered.
In the past few decades we have moved into a zero interest world and many countries have seen the opposite concern, deflation.
Ignoring inflation is therefore not unjustified.
However, as economic systems change, so do their risks.
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Given the massive coronavirus stimulus, many are suggesting that significant inflation is now inevitable.
Certain portfolios are more vulnerable to the risk of inflation.
Government bonds, corporate bonds, and other bond-like equity investments (such as utilities and consumer staples) are likely to perform poorly during periods of inflation.
Ironically, these are the best investments in most downturns.
If you are over-indebted in these areas, adding a small portion of the commodity exposure is not a bad idea.
But even if not, there is a single commodity that is suitable as a safe haven and risk diversifier.
All commodities benefit in one way or another from an expansion in global economic activity, with one exception.
Gold is a very unique metal as it is rarely used for industrial purposes.
Instead, it is hoarded by central banks and speculators as a store of value.
Since it has little industrial use, the gold price depends only minimally on the development of the economy.
In the long run, gold is not going to make you rich because its real value has not increased much since Roman times.
It protects an investor from long-term inflation while doing well in times of market stress.
There’s a reason Ray Dalio always holds a percentage of Bridgewater’s investment portfolio in gold.
Most portfolio theorists recommend a 1-5% position in gold as the value of the total portfolio.
This can be done by buying and rolling gold futures or simply by buying a gold based ETN like GLD.
Some investors will argue for other alternatives.
Silver is another commodity that has this asset.
Even so, it is also used in industry, so gold is usually a better hedge in a severe economic downturn.
Another disadvantage of silver is that it is also much more than that volatile.
This makes it more attractive to a speculator but worse to a hedger.
Emerging assets like cryptocurrencies do not currently have a diversification advantage.
Instead, the coins appear to be more of a speculative tool as they are both very volatile and tend to move with the stock markets.
However, it is noted that cryptocurrencies with a small track record could potentially become a good diversifier in the future once volatility has stabilized.
Any long exposure to commodities has a problem that most retail investors don’t know exists.
Whenever you buy commodity futures or invest in ETNs that hold them, you are expressing a view that that commodity will appreciate against the US dollar.
Therefore, your long commodity position is both a bullish view of the commodity and a bearish view of the dollar.
Since the US dollar is treated as a port currency, it does well when the markets are in turmoil.
We can see this clearly in the asset correlation below, as the US dollar has a strong negative correlation with both the S&P 500 and all commodities.
Therefore, short selling makes little sense in terms of diversification.
To offset this risk, a long US dollar position with a corresponding exposure to commodities results in a much less volatile portfolio without detracting from returns, as shown below (in blue).
Here I have taken the same graph that was originally shown with our commodity ETN in red, but then set the corresponding amount from US dollars to long long neutralize our currency risk.
If all assets are down, the US dollar is likely up!
Exposure to US dollars can be done by buying US dollar futures against a basket of currencies, holding USD cash, or buying a US dollar ETN such as UUP or USDU.
Additionally, the tiny exchange recently launched US dollar futures versus a global basket of currencies.
Commodity stocks like gold mines and oil drills offer investors synthetic exposure to the underlying commodities and can generate above average returns over the long term.
In periods of inflation, these sectors are likely to outperform.
Nevertheless, they naturally correlate more strongly with stocks than with the underlying commodities themselves.
So enjoy a stock risk premium, but don’t expect your gold mining stocks to rise in a recession.
Many indexed portfolios, especially in equity markets such as Australia and Canada, already have a strong correlation to commodities due to their sector exposure.
An investor with exposure to local stock indices in these economies is likely already over-focused on commodities.
These investors should seek to reduce their oil, mining, and industrial exposure to maximize long-term risk-adjusted returns.
Commodities are an excellent source of risk management against inflationary periods when other assets may underperform.
Gold is unique in that it can provide a store of value and diversification advantage regardless of economic regimes.
Other commodities that perform well during inflationary periods can tend to add risk during more traditional economic downturns.
Fortunately, much of this excess risk can be eliminated once an investor neutralizes their exposure to the US dollar.
Disclaimer: The information above is for For educational purposes only and should not be treated as investment advice. The strategy presented would not be suitable for investors who are unfamiliar with exchange-traded options. All readers interested in this strategy should do their own research and seek advice from a licensed financial advisor.