In this Monthly Market Advisor:

  • With the drop in commodity demand, investors are questioning whether commodities should still be included in a portfolio. 
  • In our view, there are still opportunities and reasons to include commodities in a well-diversified portfolio, the most important of which is potential risk mitigation. 
  • As the performance of each commodity depends on different factors, we believe active management is imperative.

Few investable asset classes create more passion, enthusiasm, and controversy than commodities—especially gold. With the recent significant drop in industrial commodity demand due to slowing world growth and the oversupply in oil, investors have been asking hard questions about whether commodities should be considered for inclusion in a well-diversified portfolio. Others have questions about how they should:

  • Access different sub-asset classes
  • Allocate across various commodities

Research by Wells Fargo Investment Institute (WFII) concludes (using history as a guide) that we are potentially in a long, flat commodities market. The last five years have seen some prices fall as much as 75 percent (as in the case of oil) off of their decade highs. While commodities could take years to get back to their highs last seen in 2011, we think there are still opportunities. In this monthly market advisor, we will discuss reasons to consider including commodities in a well-diversified portfolio.

Potential Efficiency of Commodities in a Well-Diversified Portfolio

In the world of portfolio management, commodities include precious metals (such as gold), industrial metals (copper), agricultural (wheat), and energy (oil/natural gas). Each of these sub-asset classes has its own characteristics and trades on different factors. We believe an asset class must possess the following attributes to warrant inclusion in a portfolio:

  • Potential to enhance return and/or mitigate risk
  • Be investable
  • Have a relevant index

WFII's research has shown that commodities in certain environments have enhanced return. In the early 1970s through the early 1980s, for example, commodities significantly outperformed most other financial asset classes as the country was in the midst of a very high inflation environment. Some commodities, specifically gold, may rally in times of economic distress as markets generally consider them as a store of wealth and as an alternative to financial assets and paper money. However, return enhancement in the asset class is very time-dependent. Thus, we now think of commodities less for return enhancement and more for risk mitigation.

From 2006-2015, commodities had negative and low correlations with investors' heaviest-weighted asset classes. For instance, WFII's research has shown that during that period commodities had a negative correlation with U.S. Investment Grade Fixed income (-0.15) and low correlations to U.S. Large Cap Equities (0.56) and Public Real Estate (0.53). Modern Portfolio Theory holds that asset classes with positive returns and low correlations with existing asset classes might warrant inclusion in the investment process.

Chart 1.Correlation Between Commodities and Various Asset Classes


Historical 10-Year Rolling Correlations, 2005-2015

Correlation Between Commodities and Various Asset Classes (2005-2015). Contact your Relationship Manager for more information.  

Correlation measures the degree to which asset classes move in sync; it does not measure the magnitude of that movement. Index correlations represent past performance. Past performance is no guarantee of future results. There is no guarantee that future correlations between indices will remain the same. An index is unmanaged and not available for direct investment


Source: Bloomberg, Morningstar Direct, Wells Fargo Investment Institute. As of 12/31/2015

U.S. Large Cap Equities = S&P 500 Total Return Index               

U.S. Investment Grade Fixed Income = Barclays U.S. Aggregate Total Return Index

Public Real Estate = FTSE EPRA/NAREIT Developed Total Return Index

Commodities = Bloomberg Commodity Total Return Index

Please see below for definitions of indices used as proxies for asset classes in the chart.


Portfolio Implementation

Investors have two main avenues to invest in the asset class: direct and indirect.

Direct investing involves actually holding the asset. This can work well and be convenient in the case of gold coins kept in a safety deposit box, but it gets much more difficult to do in large amounts and almost impossible for most other commodities, such as barrels of oil. Direct investing involves possession, including storage, insurance, and transportation costs, which add to the expense and complications of investing in the asset class.

Indirect investing includes holding companies that are naturally long (expectation that the asset price will rise) the commodity, such as an oil exploration and production company or a gold mining company. Investors can also express a bearish view by holding companies that are naturally short (expectation that the asset price will fall), such as with the case of airlines and their oil consumption. In holding publicly traded companies, investors obtain some exposure to the price movements of the commodity, but other factors such as stock market beta (beta is a measure of a stock's price volatility in relation to the rest of the market) and the company's hedging policy (for example, an airline company that is a heavy user of jet fuels is sensitive to price changes and may buy crude oil futures contracts as a hedge against crude oil price increases), can create significant differences between the price movements of the company's stock and the commodity.

Other alternatives that investors may want to consider include exchange traded products (ETPs) that strive to mimic different commodity indices that are made up of futures contracts. Such ETPs are easy to purchase and usually have low expenses, but investors should be aware of the construction of the index an ETP seeks to mirror. How the indices are composed varies greatly, which affects the ETP's performance and risk statistics. For instance, the S&P Goldman Sachs Commodity Index includes 24 physical commodities of which energy represents nearly 70 percent. On the other hand, the Bloomberg Commodity target weight for energy is 31 percent while the energy weighting in the Rogers International Commodity Index is approximately 40 percent. The different composition of these indices is neither right nor wrong, but investors need to be aware of how their commodity exposure may differ depending on the index.

Unlike a traditional ETP, most commodity ETPs are not registered as investment companies under the Investment Company Act of 1940 so they are not subject to the same regulatory requirements as mutual funds or ETPs that are registered. These ETPs can be structured as Grantor Trusts, Limited Partnerships, or Exchanged Traded Notes (ETNs). Commodity ETPs attempt to track the price of a single commodity, such as gold or oil, or a basket of commodities by holding the actual commodity in storage or by purchasing futures contracts.

They also should be aware that they are not investing in the physical asset but in exchanged-traded futures on the commodities that comprise the index the ETP tracks. The futures markets are intended to transfer risk from those who might get hurt by price volatility, such as buyers of oil when prices rally, to those who wish to take on that price risk. The futures market is the easiest way to gain exposure to commodities; however, as with other vehicles, investors should be aware of the issues and risks involved.

Since commodities are not fully correlated with each other, we believe it is imperative to actively manage one's tactical views within the asset class. There are times when industrial commodities will trade on emerging market demand, which in turn is determined by those countries' growth rates. Just 10 years ago, for example, when China was growing 10 percent or more, the demand for copper drove prices to double and triple within a matter of years. As China has slowed to a 6-7 percent growth rate, prices have tumbled along with demand.

In the oil market, prices have fallen significantly in spite of the world's appetite continuing to increase 2-3 percent a year. The price collapse is due to technological innovation making reserves that were once deemed unreachable now easily accessible, increasing the world's oil supply. It is obvious that in these markets different factors led to different price movements and that understanding each case while using active management is important.

Managed futures funds, which employ professional money managers known as Commodity Trading Advisors (CTAs) offer exposure to futures trading. Their goal is to take advantage of trends commonly found in commodities and to provide investors with return potential in up and down markets by following these trends. Managed futures are an alternative investment strategy which aims to profit from trading in financial futures, commodity futures, and foreign exchange markets. These types of investments are not suitable for all investors.

Wells Fargo Investment Institute's View

Commodity prices continue to suffer headwinds from low inflation, a stronger U.S. dollar, and sluggish economic growth. WFII anticipates periodic moves in the dollar that may increase the near-term uncertainty in prices. Overall, WFII believes this asset class could be entering a range-bound period in the coming year and recommends a diversified position.

Shorter-term cycles depend on demand, which is typically determined mainly by global growth and the appetite for expansion. Longer-term prices depend on supply and the world's ability to produce commodities. Presently, our world is awash in supply as there is too much oil, steel, and copper in the market. Thus, WFII believes that it will take a long time for prices to retrace their highs.

Commodity traders often say the cure for low prices is low prices and the cure for high prices is high prices. Today's low prices are causing production to be shut down, leading to less product in the market, which likely will eventually cause prices to rise. WFII's historical work on commodity markets has led it to conclude that since 1800 the average bear market lasted nearly 20 years while the average bull market lasted only 16 years. In each case, most of the price drop occurred during the first five years. Since this bear market started in 2011, it suggests that most of this market's carnage is over. Again, it could take years to get back to the pre-2011 prices.

WFII's research shows that there have often been opportunities within a bear market. Couple this with the potential diversification benefits of commodities exposure and WFII concludes that actively managed commodities with relevant weights to meet investors' objectives and constraints warrant consideration in portfolios. Most of WFII's portfolio models are being brought to neutral weights in commodities where investors should benefit from the risk mitigation effects of owning the asset class.

Conclusion

WFII's research has shown that commodities warrant consideration in a fully diversified portfolio. However, when choosing the appropriate implementation vehicle, investors should also consider the composition of the commodity index and understand the limits and extent to which commodity exposure can mitigate risk and when they add to return. As each commodity depends on different factors, we believe active management is imperative.