Will You Miss The Commodity Comeback?

Do Commodities Have a Place in a Portfolio?

This is an interesting question in today’s environment. Those of us who have read various finance textbooks that include sections on the benefits of things like “asset allocation” and “diversification” would, almost without thinking, say “yes.”

But if we look at the reality of what market participants have experienced in the past five years, we then recognize that, behaviorally, what has been practiced may look quite different.

U.S. Equities Delivered Very Strong Returns, while Broad Commodities Ran into the Wind

Equities Index vs Commodities Index

With some small exceptions in mid- to late 2015 and early 2016, U.S. equities have moved inexorably upward, exhibiting, at least until February 2018, historically low volatility. 15.90% average annual returns for about five years is a strong result.

For the better part of this five-year period, interest rates have remained at or near historic lows, accounting for the low returns in U.S. fixed income, but notably, this asset class was also positive and would have dampened equity volatility within a broader portfolio.

Broad commodities, on the other hand, lost almost a third of their value on a cumulative basis, or equivalently -6.5% per year.

What those with exposure to commodities have seen in the past five years has been a money-losing proposition, while their U.S. equity portfolios have had stellar returns.

Shifting Drivers of Commodity Strategy Returns

Taking a step back, it is first important to understand what factors have caused such horrible returns in commodities, because either these drivers remain powerful headwinds (and returns suffer) or they are about to shift (leading to better returns to come).

1. Collateral: In commodity strategies that utilize futures contracts to generate their commodity exposure, one component of their returns comes from the exposure of the collateral for those contracts, typically short-term Treasuries. The U.S. Federal Reserve (Fed) has embarked on a path of raising its policy rate, thereby raising collateral returns for commodity strategies from near-zero levels.