Commodities, They Are a-Changin': Portfolio Diversification Thoughts

by: Morningstar

By Mallory Horejs

There's no denying that commodities markets have rapidly evolved in the past few years. Emphasizing that point, Timothy Andriesen of the CME Group kicked-off a panel Thursday afternoon at Morningstar's ETF Invest conference with a playful word of "thanks" to Geert Rouwenhorst of SummerHaven for transforming his gold-trading strategy into a "mainstream asset class."

Less than a decade ago investors seeking commodities data or research typically found themselves out of luck. In 2004 Rouwenhorst set out to change this. In doing so, he found that commodities have some surprising benefits:

1) Attractive returns: Commodity returns over the past 50 years have been roughly the same as the S&P 500 (with dividends reinvested).

2) Diversification: Correlations between commodities and traditional assets have been very low, usually close to zero, and occasionally negative.

3) Inflation hedging: Although not a perfect hedge, commodities have been more highly correlated to inflation than stocks and bonds.

Since then, we've witnessed a financialization of commodities and seen correlations between equities and commodities spike to levels unseen during the past 50 years. While correlations typically rise during recessionary times, reasons for this extended and unusually high spike remain in part unclear, even to the panelists. Although history suggests correlation levels will eventually normalize, these recent trends still throw a wrench at diversification arguments.

To ease these concerns, the panelists paralleled this evolution in the commodities market to the recent transformation of emerging markets. Attracted by promises of portfolio diversification, investors poured money into emerging-markets equities only to find correlations higher than expected in the current decade. Yet even with correlations between developed- and emerging-markets equities approaching 0.8 today, investors haven't been deterred. There are still diversification benefits to be had, and Rouwenhorst believes it's the same story with commodities.

Conversation then turned to the often-daunting question of portfolio implementation and allocation. Andriesen noted that while a broad commodity index exchange-traded fund effectively enhances diversification, investors might require a more active, single-commodity strategy to juice returns. In terms of allocation, Rouwenhorst hesitated to cite a specific allotment, noting only that for most investors the optimal amount is "certainly greater than zero." But despite the proliferation of commodity-focused ETFs over the past few years, it appears not all investors have caught on just yet. Many remain entirely unexposed to this new asset class. Considering the slew of still-relevant benefits that Rouwenhorst and Andriesen laid out, there's certainly room for improvement on that front.

Disclosure: Morningstar licenses its indexes to certain ETF and ETN providers, including Barclays Global Investors (BGI), First Trust, and ELEMENTS, for use in exchange-traded funds and notes. These ETFs and ETNs are not sponsored, issued, or sold by Morningstar. Morningstar does not make any representation regarding the advisability of investing in ETFs or ETNs that are based on Morningstar indexes.