Commodities—raw materials including agricultural goods like wheat and coffee, energy sources like oil and gasoline, and metals like gold and copper—had a rough ride in 2014. Ibbotson Associates and Morningstar Direct ranked commodities last among 13 asset classes in terms of performance for the year. The Bloomberg Commodity Index, which tracks the performance of 22 commodities, fell almost 17% in 2014.
However, these recent challenges shouldn’t overshadow the case for including a long-term allocation to commodities in your portfolio. Commodities offer diversification benefits, potential growth opportunities and inflation hedging, and they may give investors a way to tap into potentially fast-growing emerging markets in the years ahead. Here we’ll look at why commodities deserve a place in a well-diversified portfolio.
The case for including commodities in your portfolio starts with their historical tendency to perform differently than stocks and bonds in varying market conditions. You might recall that gold surged when stocks tanked during the 2008 financial crisis, as some investors gravitated toward the perceived safety of real assets. Since no asset class performs well consistently, having exposure to uncorrelated investments that don’t move in lockstep helps reduce portfolio risk.
To see how the benefits of diversification might play out in a portfolio, consider how two hypothetical investments of $100 at the beginning of 1970 would have played out by the end of 2014:
- $100 invested in U.S. large-company stocks (as represented by the S&P 500® Index) would have grown to $8,854, excluding fees and expenses. That’s an average annual return of 10.48%.
- $100 invested in commodity markets (as measured by the S&P GSCI® Index) would have grown to $3,233, representing an average annual return of 8.03%.
Now imagine that $100 had been invested in a 50/50 split between the two and rebalanced annually. That portfolio would have grown to $8,551—an average annual return of 10.39%. While the value of the 50/50 portfolio would have been slightly less than that of the U.S. large-company stock portfolio at the end of 2014, the 50/50 portfolio would also have been 16% less risky. In other words, combining stocks and commodities in a portfolio can help mitigate its overall risk. This is the value of diversification—smoothing the ride over time.
Unlike stocks, commodities don’t generate earnings or dividends, so returns are driven by supply and demand. Commodity prices are influenced by consumption and the scarcity of raw materials, as well as speculation about future price movements.
We looked at how commodities’ inflation-adjusted returns stacked up against those of stocks and bonds from 1970 to 2014. As you can see in the chart below, commodities haven’t performed as well as stocks or bonds recently, but during some periods commodities have done very well.
A variety of factors hurt commodities in 2014—oil prices were wracked by rising supply and slowing global economic growth, a bumper grain harvest in the United States depressed prices, and a surging U.S. dollar forced other countries to pay more for commodities priced in dollars. While these factors seem set to persist over the short term, that doesn't mean they'll be around forever. If global growth accelerates, commodities will likely benefit, particularly as demand and consumption recover in emerging markets. Increased middle-class consumption in China has been a boon for commodities in the past, just as strong growth in other emerging countries could give a boost to commodities in the years ahead.
Commodities have historically outperformed stocks during periods of inflation, which could make them a useful hedge against rising prices. The advantage of an inflation-hedging component in your portfolio may not seem as evident in periods when inflation is low, as it has been in recent years, but the benefits are quite clear over longer periods of time.
We compared how stocks and commodities performed between 1970 and 2014 during periods when inflation was below 2%, in a moderate 2–4% range and more than 4%. As the chart below shows, commodity returns have increased in periods when prices are rising briskly. That kind of performance is valuable when inflation is eroding the returns on financial assets.
Of course, not all commodities are the same—and each has its own unique risks. For example, the four-year drought in California may continue to hurt agricultural production, leading to higher prices. And turmoil in the Ukraine and the Middle East has led to wide swings in natural gas and oil prices.
Still, the case for allocating at least a part of your portfolio to commodities is clear.
Commodities took a drubbing over the past 12–18 months, but that doesn’t mean investors should run for the hills and banish them from their portfolios.