The case for commodities
How to use the asset class as a diversifier
Oil, precious metals and agricultural crops - they all fall under the term 'commodities' when it comes to investing.
Many investors think of commodities as not only a way to diversify portfolios, as the performance characteristics of commodities are uncorrelated to the performance of equities, but also as an inflation hedge.
However, commodity prices have been more volatile recently, in line with stockmarkets more generally.
So should clients still have exposure to this asset class? Is there a long-term case for allocating to commodities? And, if so, what types of products give them the most suitable exposure, given that many may prefer holding the physical asset over equities, such as shares in mining companies?
Read on to find out how advisers' clients are currently positioned in commodities and the wider role commodities can play in portfolios.
Volatility concerns keep clients' exposure to commodities down
The majority of investment clients have less than 10 per cent of their portfolios exposed to commodities, financial advisers have revealed.
But a significant percentage also had clients with no exposure to this asset class at all, according to the latest FTAdviser Talking Point poll.
When asked how much exposure to commodities, on average, their clients had, 50 per cent of advisers polled said less than 10 per cent, while 36 per cent of advisers said their clients had none at all.
Dennis Hall, chief executive of Yellowtail Financial Planning, said: “I’m also in the group that has zero direct exposure to commodities and I’m comfortable with this.
“I acknowledge that I have an indirect exposure to commodities through a diversified portfolio of holdings that will include things like mining stocks. These will tend to be loosely correlated with the underlying demand for commodities.”
Oil prices have climbed again recently, with the price of Brent oil, the international crude benchmark, reaching nearly $80 (£60) a barrel in recent weeks.
Despite this, only 3 per cent of advisers polled said their clients had between 15 and 20 per cent of their portfolios allocated to commodities such as oil, while 11 per cent confirmed that clients had less than 15 per cent exposed to this asset class.
James de Bunsen, portfolio manager on Janus Henderson’s UK-based multi-asset team, said the best way for most investors to get access to a physical commodity was via exchange-traded funds.
But he suggested: “Of those people who said they had them [commodities in their portfolios], probably most of them have only got gold and nothing else.
“I think people see gold as something different because is it a currency or is it a commodity? It’s probably, in many ways, more similar to a currency than any of those other major commodities that feature in the indices.”
Mr de Bunsen suggested people had gold in their portfolios mainly as a hedge against geopolitical risks and a hedge against quantitative easing (QE) going wrong.
“That was one of the big reasons for people holding gold a few years ago,” he added.
Mr Hall questioned whether commodities as an asset class was a useful diversifier in clients’ portfolios, “given the additional risks and higher level of volatility that commodities can bring”.
“My own opinion is that adding commodities to a portfolio is simply adding a higher level of speculation to the portfolio – it may pay off, though in the long run I doubt it does,” he added.
When investors talk about commodities, it is actually a diverse group of assets they are referring to in that catch-all term.
Funds investing in commodities may be positioned in anything from oil to precious metals such as gold, silver and platinum, and to agricultural crops, including coffee, wheat and corn.
Perhaps the most well-recognised commodity and one that investors may be most familiar with is oil.
James de Bunsen, a portfolio manager on Janus Henderson’s UK-based multi-asset team, acknowledges the asset class is “a diversified bunch of underlying commodities”.
He says: “To lump them together may be a bit spurious but it’s just for ease.”
Supply and demand
When discussing whether there is a long-term case for having exposure to commodities in client portfolios then, it is worth bearing in mind not only the different types of commodities within an allocation to the asset class, but also the varying drivers affecting their price.
“They all have their own supply and demand dynamics, so what’s relevant for oil is probably not so relevant for wheat, or copper,” Mr de Bunsen points out.
With precious metals, copper and platinum, for example, have industrial uses that affect the price of these commodities, while gold prices are typically linked to central bank buying and demand for gold jewellery in India and China.
“There are a couple of things that do link them and that’s they’re all denominated in dollars. So all things being equal, if the dollar goes up, that puts a bit of pressure on commodities and vice versa,” he adds.
For many investors, the role of commodities in a portfolio is to act as a diversifier.
Most commodities are uncorrelated to equities, which is what makes them a useful diversification tool.
But Philip J Milton, managing director and investment manager at Philip J Milton & Company, cautions: “I cannot say I should just buy commodities as an ‘alternative’, as if they are up with economic events too, then they’d all fall the same [direction] as equities anyway.
“Of course, it would be naïve to imagine that all alternative assets (save perhaps precious metals as real alternatives) would be protected, or indeed work in the opposite direction to equities.
“But sometimes it can be just a case [having] exposure to some uncorrelated assets, which have properties that are different [to those of equities or bonds].”
Mr Milton's point about commodities and equities moving in similar directions at times is reflected in the latest volatility data for both asset classes.
In its 2018 mid-year global market outlook, Bill Street, head of investments EMEA at State Street Global Advisors, warns commodity volatility has resurfaced as market volatility more generally “has returned to normal levels”.
He also points out inflation is “trending higher”, although he goes on to forecast this will remain contained for the rest of the year.
Mr Street warns: “Commodity price jumps pose more immediate risks to inflation.”
This may seem odd, as the asset class can often act as a form of inflation protection.
Mr de Bunsen explains this is the other shared trait commodities have.
“Sometimes they can cause inflation, particularly in emerging market countries – food is a big part of the underlying inflation indices and still a big part in the developed world,” he notes.
“Commodities can cause inflation but also if people feel there’s inflation out there or inflation coming, then the prices can react ahead, it can front-run actual inflation numbers because people assume that commodity prices are going up.
“In a way you can, to a certain extent, see this as a reasonable asset class to hold if you expect there to be inflation.”
Gold, in particular, which is often referred to as a ‘safe haven’, is known for being a hedge against inflation, specifically US dollar inflation.
Matt Tagliana, head of ETF products at Invesco, confirms gold’s role as a safe haven asset is well established and that it continues to serve this purpose today in investors’ portfolios.
“This is unlikely to change, as one of the basic results of modern finance is that adding additional diversifying assets to a portfolio allows investors to achieve a better risk-adjusted return,” he suggests.
“So, unless gold became very highly correlated with stocks or bonds, it would still have a place.”
He continues: “As for replacing gold with other commodities, it’s not really a like-for-like substitution.
“Gold is viewed as a currency proxy and inflation hedge and its price is impacted by different factors and in different ways than, for example, energy products such as oil, or a base material like copper, or an agricultural crop like wheat.”
This brings investors onto how to get exposure to commodities in their portfolios.
There are numerous ways to allocate to commodities – and that’s not just the usual active versus passive exposure, although that does apply, of course.
Some investment funds will give investors equity exposure, while others will allow the investor to hold the physical asset, such as gold bars.
Mr Tagliani comments: “While they all fall under the broad heading of ‘commodities’, substituting one for another is really a fundamental shift in your exposure.
“For this reason, many investors looking at commodities choose to use broad-based commodity products to get diversified exposure to the whole space.”
In July, Lazard Asset Management launched a Global Commodities fund investing in commodities and commodity-related equities in order to “access a broad universe”.
The fund is managed by the Lazard commodities team, led by portfolio manager and analyst Terrence Brenna.
In the accompanying press release, he says: “Our investment philosophy is based on value creation through fundamental analysis of commodity futures and related equities, including meaningful ESG [environmental, social and governance] considerations.”
Some investors may not be comfortable with having so much exposure to commodity equities however, given that the asset class is meant to be uncorrelated to equity markets and equity markets have performed strongly over the past few years.
Mr de Bunsen notes: “I think the problem is what you’re getting is a lot of equity risk [when holding a fund] which might take away from the fact, in some people’s minds, they’re buying commodities because they’re hoping for a diversifier.
“I think there are some times when buying commodity stocks is a better thing to do because of the valuation or whatever. But at the same time, what you shouldn’t expect is for them to be necessarily uncorrelated to the other things in your portfolio.”
He adds: “They are, after all, equities. If the equity market falls 20 per cent, it’s pretty likely they’re going to do something similar.”
For those clients who specifically want an allocation to gold in their portfolio, it is unlikely they will get that via an actively managed fund.
Mr Tagliana observes: “Gold represents a larger portion of total ETP [exchange-traded product] assets than would be expected based on the allocations most investors make to gold in their portfolios.
“This suggests investors find ETPs are an attractive means of gaining exposure to gold, as opposed to direct investment or commodity futures. The ongoing competition between issuers offering gold ETPs means that the fee levels on these products are quite reasonable.”
So are advisers allocating to commodities in client portfolios?
And are managers using commodities as a hedge, given the inflationary environment?
“Yes, we have introduced some commodities to strategies to try to select alternative defensive assets to bonds, which may prove to be the most defenceless assets of all time if or when interest rates start rising,” Mr Milton explains.
“We have tried to use ‘cheap’ and staple commodities too, so when you look at, say, wheat and agricultural products, these are pretty low historically – the theory being that we’ll still be eating despite the financial affluence we may or may not feel.”
But some financial advisers view commodities as a speculative investment and do not recommend these assets for client portfolios.
Dennis Hall, chief executive of Yellowtail Financial Planning, says they “simply add a higher level of speculation to the portfolio”.
Joshua Gerstler, financial adviser and company director at The Orchard Practice, refers to gold specifically as “a punt”.
“I believe that gold is a speculation not an investment,” he reasons.
“Shares should provide you with dividends and property should provide you with rental income. Gold provides you with nothing.
“When you buy gold you are doing so in the hope that someone will buy it from you in the future for more than you paid for it.”
But for many portfolio managers, gold has a valuable role to play in their funds, as a hedge against overblown markets, for example, or a weakening dollar.
Tilney recently announced it was halving its exposure to physical gold across its central investment strategies, including its Multi-Asset Portfolio range which comprises seven funds, having initiated its investments in the asset at the end of 2015.
Ben Seager-Scott, chief investment strategist at Tilney, explains the gold trade “has served portfolios well, especially as we moved through a period where markets have been driven more by liquidity than fundamentals”.
“With the investment landscape changing, it seems appropriate to review these positions, and begin taking profits. The gold positions effectively substituted for distorted fixed income markets which are now close to normalising in the US.”
Mr Seager-Scott confirms that “with gold having done its job, now we can start returning to a more traditional footing”.
“In place of gold, we have increased our positions in short-dated US Treasury inflation-protected securities, which we believe will still offer some portfolio protection during risk-off periods,” he notes.
Meanwhile, Lazard Asset Management launched its commodities fund due to what it believes is investor demand.
Tony Maddock, head of third party distribution at Lazard, says: “With increased concerns about duration risk and rising inflationary pressures, it is important for our clients to have the right commodities exposure within their portfolios.”
House View: Commodities - is now a good time to invest?
Before we provide readers with the merits of investing in commodities, it is important to highlight how dreadful investor returns have been across the broad commodity complex since 2010.
In fact if we look back to the dark days of January 2009, during the financial crisis, any investor that invested £1,000 in the broad commodity complex (represented by the Bloomberg Commodity Total Return index) would have suffered a 28 per cent loss on their investment.
In contrast, if investors had put the £1,000 into US equities (S&P 500), global equities, global high yield or Reits, they would have seen their portfolio increase by around 200 per cent profit.
From our perspective, the recent weakness in metals, and agricultural commodities in particular, has been a direct result of the unprecedented targeting of tariffs between the US and its previously regarded ‘important’ trade partners, such as Mexico, Canada, the EU and China.
Investor sentiment for commodities has never been so low.
However, if we step back and look at the individual commodities, purely from an unemotional fundamental perspective, for many of the energy, metals and agricultural commodities, the supply and demand balances look very tight indeed, and with prices being at multi-decade lows, the market is not recognising this structural tightness right now.
Many individual commodity prices, in inflation-adjusted terms, remain well below the highs seen in the 1970s and early 1980s.
For this reason it is clear to us that given commodities are so cheap relative to many other asset classes, this is no doubt one of the main reasons why we have started to see investors slowly coming back to commodities and commodity related equities.
However we should also remind investors of the other reasons why investors are dusting off the ‘investing in commodities’ folder right now:
• Portfolio diversification - History tells us that commodities tend to hold a low to negative correlation to traditional assets. Therefore, commodities offer a good way in which to diversify a portfolio’s risk assets away from traditional asset classes such as bonds.
• Geopolitical hedge - Looking at North America, South America, Europe and Asia, it is hard for anyone to make the case that geopolitical relations are better than they were five years ago and, from where we sit, unless the rhetoric changes (from one individual in particular) it is difficult to see how these relationships do not deteriorate further over the few years ahead. In the past, in periods of heightened geopolitical risk, commodities in particular have performed as a good natural hedge against geopolitical events.
• Protection against rising inflation - Rising commodity prices have historically been a major contributor to rising inflation, poor financial asset performance and tighter monetary policies. Commodities therefore provide excellent protection for those with inflation-linked liabilities, as well as those who seek liquid and accessible ‘real asset’ investments.
The key point here is ‘rising inflation’ - not high inflation, rising inflation.
This is a big misconception among investors; many think that commodities just perform well in periods of high inflation, but this is actually not precise enough.
If you go back to analysing the annual returns of three common investment subsectors (equities, bonds and commodities) since 1976, it is very clear that during periods of falling and subdued inflation, commodities perform poorly, but when inflation starts to pick up, even from a low base, commodities significantly outperform equities and bonds.
This is another key message for potential commodity investors: you don’t need much exposure to protect real returns in your portfolio in a rising inflationary environment.
All the signs are showing that inflationary risks are rising - while not very high, it is clear to us that US core inflation has definitely started to increase and this is feeding through into CPI which is heading towards a rate of 3 per cent year-on-year (note this compares to an annual CPI rate of just 1 per cent year-on-year two years ago).
In Europe, CPI has increased from almost zero in June 2016 to just under 2 per cent in June 2018, albeit from a low base, the trends are positive.
Coming back to the fundamental supply balances for commodities, we will finish by reminding investors that commodities are cyclical industries.
Remember, “the best cure for low commodity prices are low prices” and as a result of many of these commodities trading below the average cost of production for the last few years, new project capital expenditure (future supply) has collapsed to historically low levels, which we believe will have a negative impact on supply over the next few years.
The only way investment can be increased is if prices recover.
Mark Lacey is head of global commodities and resources at Schroders