There are plenty of good reasons why commodities continue to generate interest amongst investors. Global demand, particularly in emerging countries like Brazil, India and China, has resulted in a multi-year natural resources bull market that shows little signs of abating. In addition, commodities are a distinct asset class with returns that are largely independent of stock and bond returns. Therefore, adding broad commodity exposure can help diversify a portfolio of stocks and bonds, lowering risk and potentially boosting returns.
Achieving this exposure to commodities has been made easier with the development of investment products that specifically track a broad range of commodity. These products include ETFs and ETNs tied to commodity futures indexes like the Dow Jones-AIG Commodity Index (DJP), the S&P/Goldman Sachs Commodity Index (GSCI), as well as other funds linked with specific commodities or commodity sectors, including gold, silver, oil, copper, energy, grains, livestock and other precious metals.
Investors are using these products to increase their exposure to the commodities market, looking to add diversification and extra returns to their portfolio.
Closet Commodity Exposure
One key to developing a successful asset allocation program, however, is to understand first what assets you already hold. And in the case of commodities, most investors already have some exposure to the space … even if they aren’t aware of it.
The S&P 500 is one of the most frequently cited benchmarks for the U.S. economy and for the stock market as a whole, and is widely held in investors' portfolios. The Index’s components come from all major industries, so naturally, you would expect some exposure to companies in the commodity business as well.
And at a quick glance, you’d be right. Of the 500 companies in the Index, Standard & Poor’s classifies 34 as energy companies, including Sunoco, Valero Energy and Exxon Mobil. It classifies another 29 companies as “materials” businesses, a broad category that includes non-commodity producers but also commodity businesses such as Newmont Mining, US Steel, and Freeport-McMoran Copper & Gold.
However, a closer look at the components in the S&P 500 Index shows meaningful exposure to energy, but very little to mining and other “hard asset” categories. As of September 30, 2007, according to Vanguard, 11.7% of the S&P 500 assets were in energy companies, while only 3.2% were in materials companies.
Out of the 34 companies in the Index categorized as “energy” stocks, the vast majority (33, to be exact) of them are in oil and/or natural gas exploration, development, refining and distribution, or provide equipment, tools and services to oil/natural gas explorers. One, Peabody Energy, is primarily in the coal exploration and mining business. So the 11.7% in S&P 500 assets that are categorized as “energy” are in fact oil and natural gas plays, with a sprinkle of coal added in. Investors buying the S&P 500, then, gain substantial (if indirect) exposure to oil and natural gas.
It’s a different story with the 29 S&P 500 companies categorized as “materials.” We’re hard pressed to identify more than a few commodity-based businesses in the group, particularly those in the business of producing hard assets such as gold, silver, copper and other natural resources. Here’s the short list: Freeport-McMoran Copper & Gold, Alcoa [aluminum], Newmont Mining [gold], Nucor [steel], US Steel [steel], Allegheny Technologies [metals] and Titanium Metals [metals]. That’s it: seven companies in the entire S&P 500 involved in “hard asset” production and distribution. Together these seven companies account for just 1.02 percent of assets in the S&P 500.
(If you want to break it down further, you have less than a 0.30% exposure to precious metals, as the only company involved in that space is Freeport McMoran, and its efforts are split between copper, gold and other metals. We’ll assign half the weight of Freeport McMoran to precious metals and half to industrial metals.)
Gauging the weight of “agriculture” in the index is difficult, because there are precious few companies that offer pure-play exposure to the agricultural market. But even if we cast the net wide, including companies like Dupont (which makes fertilizer and pesticides but also many, many other chemicals), you still arrive at a very small exposure to the market. Using our wide net, we identified seven companies with significant involvement in agriculture: Archer-Daniels Midland, Caterpillar, Dean Foods, Dupont, John Deere & Co., Monsanto and Tyson Foods. Together, they account for just 1.56% of the index.
Commodities Exposure Within The S&P 500
With these numbers in mind, it is no wonder that, over time, there has been correlation between the S&P 500 and major commodity indexes.1 During the 15-year period between 1991 and the end of 2006, the S&P 500 had a correlation of 0.09 to the Dow Jones/AIG Commodity Index and a correlation of -.02 to the S&P GSCI Crude Oil Index.
What does this mean for asset allocation? It means that investors who hold large positions in the S&P 500 should consider the commodities exposure they gain within the index when developing an asset allocation strategy.
The S&P 500 provides substantial exposure to the energy markets, and particularly to oil and natural gas components. Other commodity sectors, however, such as gold, silver, copper and agriculture, are not as well represented in the S&P 500. Investors looking for balanced commodities exposure may want to increase their exposure to those markets, while adding less exposure to the energy sector. They could do so by focusing on non-energy-heavy commodity futures indexes like the DJ-AIG (as opposed to the GSCI), or by turning directly to gold, gold stocks, industrial metals or agriculture if they are particularly bullish on an individual sector.
1 As a refresher, correlation values range between -1 and +1. Assets that have an inverse relationship, or move in exact opposite directions, will have a correlation of -1, while those that move in the same direction in tandem will have a correlation of +1. A correlation of 0 implies that there is no relationship.
2 Keep in mind that investing in hard asset stocks is not the same thing as investing directly in commodities, as discussed in depth here.