In the past few years, some investors cooled on the idea of holding commodities in their portfolios, saying the recent investing environment meant reasons to hold natural resources no longer existed – such as portfolio diversification and inflation protection. But several commodity experts say the investing landscape is changing and it’s time again to look at the sector.
Like any asset, these experts say money managers need to review their clients’ needs before adding commodities back to their holdings as there are several ways to get exposure.
Traditionally, commodities were considered portfolio diversifiers as they were not correlated with stocks and bonds. However, after the global financial crisis, various markets became correlated due to the “risk on/risk off” trading tendency. Correlations between commodities and equities had spiked to an unusually high level of around 0.7 at times, based on a rolling 90-day timeframe, when normally it is closer to zero, says Jodie Gunzberg, global head of commodities at S&P Dow Jones Indices.
Historically high correlations between commodities and equities are relatively rare, she says adding there were only four times since 1970 that commodities and equities dropped during the same year – 1981, 2001, 2008 and 2011.
Bob Greer, executive vice president and real return product manager at PIMCO, says since 1973, using a 24-month rolling timeframe, there was only one time that the correlation between equities and commodities reached 0.6, and after spiking not only did the correlation drop, but it turned negative.
That’s what commodities are seeing today.
With the correlation back to normal, “that means a portfolio that includes commodities is potentially more diversified and likely to have a better risk-adjusted return than one concentrated in stocks and bonds,” Greer says.
The drop off in correlation comes as commodities are trading on their own supply and demand fundamentals, Gunzberg and Greer say.
“When inventories fall, supply-side shocks like drought or pipeline bursts or geopolitical tensions matter. That’s what drives the return patterns to be different from each other and to be different from equities,” Gunzberg says.
Positive Roll Yield
Greer says roll yield is now positive, too. A positive roll yield means investors profit by moving their futures holdings from a more-costly nearby price to a cheaper deferred price because of backwardation.
“It is nice to be actually paid to own commodities,” Greer quips.
Gunzberg notes 2013 was the first year since 2003 for commodities to exhibit a positive roll yield, and considering that most commodity investors entered the sector in a big way in 2005, they’re not familiar with the concept of backwardation. Additionally, the positive roll yield for index has continued this year.
“(Backwardation) really changes the picture for the opportunity for commodity investors in the front month index,” she says.
It’s possible that the positive roll yield may be here for a while.
Hilary Till, principal, Premia Risk Consultancy, Inc., and research associate, EDHEC-Risk Institute, wrote a research paper outlining that the structural shape of the crude oil futures curve might be returning to the shape it typically held from the 1980s through the early 2000s. Crude oil was used because of its important weighting in commodity indexes.
Till cited research by Goldman Sachs, noting that from March 1983 through February 2003, the NYMEX West Texas Intermediate futures contract was in backwardation 62 percent of the time, with an average yield of 0.78 percent per month. What changed in 2004 was the surprising rise of Chinese demand, resulting in a temporary collapse of immediately deliverable spare capacity from the Organization of Petroleum Exporting Countries, Till says.
Since that time, however, the global crude oil picture is changing with the rise of U.S. shale-oil output. Higher U.S. oil production adds to OPEC’s spare capacity cushion as less corresponding oil will be needed from OPEC
Using Commodity Diversification Properly
Inflation has not been an issue in the past few years, but it may be a concern for the future. Greer says PIMCO’s forecasts call for inflation to rise slightly in 2014, and there remains concern about inflation risk in the longer-term because of central banks’ ultra-loose monetary policy. If there are unexpected rises in inflation, “commodities can be a direct shock absorber for unanticipated spikes in inflation,” he says.
With commodities returning to trading on their fundamentals, there are more opportunities for active management, according to Greer.
“There are more robust opportunities to generate alpha, now that commodities are being driven by fundamental factors,” he says.
Read More: The New Role for Commodity Indexes
Savvy commodity investors can use both strategic and tactical positioning. Those with a more active view can still use indexes, Gunzberg says, such as trading spreads, whether it is something as simple as trading Brent crude oil versus WTI, calendar spreads or spreads between commodities with similar underlying sectors.
“That’s become really popular in indexing. Now that indexing has been around for some time, investors feel more comfortable using some of the single commodities and single strategies to create their own alpha,” she says.
Using historical analysis of commodity returns, Till outlines a few points for investors considering a commodities weighting. Investors who seek portfolio diversification and want protection against oil shocks, need to ensure a “healthy, structural weighting to the petroleum complex,” she says, also pointing out past performance doesn’t guarantee future results.
Those who seek consistent returns must be aware of term structure, she advises. “Over the long term, commodities with positive returns have been structurally backwardated. One also needs an appropriate rebalancing routine to capture the portfolio-level effects arising from the mean-reverting properties of spot-commodity prices,” Till says.