Commodities: Diversification or Diworsification?
Do commodities enhance a typical 60/40 (stock/bond) portfolio?
That depends on a) who you ask, b) when you ask them, c) how you define “enhance,” and d) how you define “commodities.”
In 2005, Gorton and Rouwenhorst found that an equally-weighted index of commodity futures (from July 1959 to December 2004) had historically produced the “same return and Sharpe ratio as equities” while being “negatively correlated with equity returns and bond returns.” Armed with these findings, they asserted that “commodity futures are an attractive asset class to diversify traditional portfolios of stocks and bonds.”
Not long after this study, in February 2006, the first broad-based commodity ETF was launched. The PowerShares DB Commodity Index Tracking Fund (DBC), designed for “investors who want a cost-effective and convenient way to invest in commodity futures.”
The DBC ETF invests in futures contracts of “14 of the most heavily traded and important physical commodities in the world.”
Let’s say an investment advisor decided, after the launch of this commodities ETF, to shift their asset mix from 60/40 (U.S. Stocks/U.S. Bonds) to 50/30/20 (U.S. Stocks/U.S. Bonds/Commodities). How would they have fared?
Initially, quite good.
From March 2006 through June 2008, Commodities (DBC) gained 101.8% versus a gain of 12.0% for Bonds (AGG, Aggregate US Bond ETF) and 4.6% for U.S. Stocks (SPY, S&P 500 ETF).
A diversified portfolio including commodities over this period had an annualized return of 9.3% with volatility of 5.5%, comparing favorably to the 3.3% annualized return with 6.4% volatility for the stock/bond portfolio. The theoretical research suggesting commodities were additive to a stock/bond portfolio was playing out in real life.
Note: All data herein is total return including interest/dividends.
And then it stopped. Crude Oil crashed in the back half of 2008, suffered another crash from 2014-2016, and Commodities never recovered. All of the diversification benefits from 2006-2008 disappeared and then some.
In the full period from March 2006 through December 2016, Commodities (DBC) lost 27.5% versus a gain of 118.4% for U.S. Stocks (SPY) and 56% for U.S. Bonds (AGG). To make matters worse, they suffered those losses with significantly higher volatility (20%) and a relatively high (0.50) correlation to U.S. equities.
The result: a diversified portfolio which included commodities during this full period gained 4.8% with 10.1% volatility versus a gain of 6.4% and volatility of 9.2% for the stock/bond portfolio. Instead of diversification, investors got diworsification.
What went wrong?
Gary Antonacci recently tackled some of the major issues in a highly informative post.
To summarize:
Increased participation in and financialization of commodities may have led to higher correlations to equities and to each other (see here, here, and here).
Those correlations reduced portfolio returns derived from “mean reversion profits,” where investors were previously benefitting from rebalancing.
Financialization also led to declines in roll yields with lower expected returns.
Lower U.S. Treasury bill returns have reduced collateral returns.
More long-only money reduced the premium speculators were receiving from hedging.
Antonacci cites three recent studies which conclude that, in light of recent data, commodity futures do not add value to a stock/bond portfolio (see here, here, and here).
Case closed? Maybe not.
Wes Gray of Alpha Architect had a very instructive post on the topic, citing a study by AQR which concluded otherwise. The AQR study has the longest sample size (1877 to 2015) and found that “even a 10% allocation to commodities adds value over a traditional 60/40 stock/bond allocation.”
(Note: They found the “optimal allocation” (optimizes Sharpe Ratio) to be 54% government bonds, 29% stocks, and 17% commodities.)
Theory vs. Practice
There is a lot to digest here and no definitive answers for investors. Even if we assume that commodities are additive (good diversifiers) over the long, long term (1877), the hurdle in adding them to a portfolio today is high for three reasons: 1) the lack of education most investors have when it comes to commodities, 2) recent commodity returns/volatility, 3) the higher costs associated with commodity ETF products (DBC has a total expense ratio of 0.89%).
As I wrote in my last post on factors, investors don’t hold on to things they don’t understand. At the first sign of hardship, they bail. Commodity futures are much more complicated animals than stocks/bonds and investors will have a harder time holding onto them when times are bad.
Assuming you can get over that hurdle, the higher one today is recent performance/volatility. Investors chase past returns/volatility. By past, I mean recent past (3 years or less). Investors were very receptive to commodities in June 2008 because they had strong recent performance and were compensated for taking on volatility. Since then, they have not.
Convincing investors that commodities will help their portfolio without recent returns backing that up is an almost impossible task. And in the new world order of low cost, passive investing, an expense ratio of 0.89% simply does not make the cut.
If commodities go on a multi-year rally from here while stock/bond returns are subpar, that conversation would change as investors would have their “proof” and would pay up for higher past returns. But by that time it might be too late for investors to actually benefit from adding them.
In the end, there is theory and there is practice. In practice, few investors will choose to add commodities to a diversified portfolio until commodity returns significantly improve. Is that an active decision? Sure it is (commodities are part of the true “market portfolio”), but the real question is whether it is a good decision or a bad one. Since the advent of broad-based commodity ETFs in 2006, it has been a good one. In the long, long term, the jury is still out.
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This writing is for informational purposes only and does not constitute an offer to sell, a solicitation to buy, or a recommendation regarding any securities transaction, or as an offer to provide advisory or other services by Pension Partners, LLC in any jurisdiction in which such offer, solicitation, purchase or sale would be unlawful under the securities laws of such jurisdiction. The information contained in this writing should not be construed as financial or investment advice on any subject matter. Pension Partners, LLC expressly disclaims all liability in respect to actions taken based on any or all of the information on this writing.
CHARLIE BILELLO, CMT
Charlie Bilello is the Director of Research at Pension Partners, LLC, an investment advisor that manages mutual funds and separate accounts. He is the co-author of four award-winning research papers on market anomalies and investing. Mr. Bilello is responsible for strategy development, investment research and communicating the firm’s investment themes and portfolio positioning to clients. Prior to joining Pension Partners, he was the Managing Member of Momentum Global Advisors and previously held positions as a Credit, Equity and Hedge Fund Analyst at billion dollar alternative investment firms.
Mr. Bilello holds a J.D. and M.B.A. in Finance and Accounting from Fordham University and a B.A. in Economics from Binghamton University. He is a Chartered Market Technician (CMT) and a Member of the Market Technicians Association. Mr. Bilello also holds the Certified Public Accountant (CPA) certificate.
You can follow Charlie on twitter here.