The Commodity Conundrum
Commodities are often a topic of discussion for investment professionals and the media alike given the sharp moves that are typical of this segment of the market. Plus, the composition of the Canadian marketplace means that this topic is afforded even more attention north of the 49th parallel. Many have recently declared an end to the latest commodities bull run or super-cycle and so we thought it would be timely to take this opportunity to review the idea of a dedicated long-term allocation to commodities in client portfolios.
Everyone recalls the heady days of commodity price advances, which took hold in the 2000s and saw a basket of various commodities experience price appreciation on the order of 150% in just 5 years [between 2002 and 2007]. The first investable commodity futures index was the Goldman Sachs Commodity Index, created in 1991 and followed shortly thereafter by what has since become the Dow Jones-UBS Commodities Index. Other commodity indices include the Reuters/CRB index (the old CRB Index, which was restructured in 2005) and the Rogers International Commodity Index.
The DJ-UBS is composed of futures contracts on physical commodities and is designed to minimize concentration in any one commodity or sector. The weightings for each commodity included in the index are calculated in accordance with rules that ensure that the relative proportion of each of the underlying commodities reflects its global economic significance and market liquidity. Annual rebalancing and reweighting ensure that diversity is maintained over time.
source: A Wealth of Common Sense (Blog) www.awealthofcommonsense.com
The returns above are in USD, which is the most appropriate means of evaluating the potential contribution of commodities to overall portfolio returns, without introducing secondary currency effects. We fully appreciate that a Canadian investor is subject to the vagaries of the foreign exchange market, but that is outside the scope of this piece. You can see that commodities provided the lowest return when compared to the S&P 500, as well as mid-cap, small-cap, international and emerging market equities and bonds too. An interesting side note is that the 25-year return [to 12/31/2013] for the S&P/TSX Composite Index was 8.35% while the materials sub-sector return was just 4.81%, which suggests that there was significant underperformance in Canadian commodity stocks as well.
What’s more, commodities are generally at least as volatile as equities and we know that big moves are always possible…both upwards and downwards. And, despite the perceived benefits of adding commodities, recent research suggests that adding them to a portfolio actually serves to increase overall volatility. Presumably this has something to do with the fact that the correlations between commodity investments and equities in general, have increased significantly since the onset of the Global Financial Crisis. And, it should be noted that commodity investments are the only category that remains below pre-crisis highs. Clearly, some of the other asset classes are higher risk than commodities, but they have generated substantially greater returns in each case.
We would also like to remind you of the most frequent criticism leveled at commodities, which is that this asset class fails to generate earnings, pay dividends or interest, or build any long-term value, as is the case for a business.
A well-diversified bond and equity portfolio tends not to benefit, in terms of overall return or risk, from dedicated commodity exposure. Besides, Canadian investors will tend to be well-represented in the commodities sphere by virtue of the tendency to overweight Canadian equities and the materials-heavy composition of our marketplace. Recall that Canada represents only 3% of global investment opportunities. There will be periods of outperformance, but these will be difficult to predict and so we remain convinced that a specific allocation to commodities is not necessary to have a well-diversified portfolio and that long-term returns are not likely to be enhanced by such an approach. Should you wish to discuss how your portfolio is already exposed to commodities please contact your investment counsellor.