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SUMMARY
- Investing in commodities can provide increased diversification to the traditional 60/40, in our view.
- Direct commodity investing can be complex and provides no regular cashflows.
- We believe that investing in commodity-levered equities is preferable in the current environment.
Following 2022, a year which saw the worst return for a ‘60/40’* balanced portfolio since 1942, it is natural for investors to begin looking for an alternative to stocks and bonds. Through this search for alternative asset classes, several of our clients have approached us with questions regarding commodity investing. While commodities are a common subject in the media, investing in them requires different analysis than stock and bond investing. We would like to discuss our current views on commodity investing in this Strategic View.
* We define ‘60/40’ here as a portfolio comprised of 60% Large Cap US stocks and 40% 10-year US treasury bonds.
Diversification Benefits of Commodities
The primary benefit to commodity investing, in our view, is diversification. The commodity space contains four major sectors: energy, agriculture, industrial metals, and precious metals. A diversified basket of these commodities tends to have long term returns that differ from stocks and bonds. To the right is a table of daily return correlations** between the price returns of US large cap stocks, US bonds, and commodities, looking back over the past twelve months.
** We define correlation here as the degree to which two sets of price data are related to one another; for instance, a correlation close to 1.0 would imply an extremely strong relation, meaning that those two investments would have returns of similar magnitude for any given period, while a low correlation close to 0.0 would imply close to no relationship, meaning their returns are unrelated, in our view.
Over the past year, commodity investments have had a low correlation to both bonds and stocks. This low correlation can be seen in the table above. For example, commodities are only slightly correlated to the S&P 500, which can be seen with the 0.14 correlation ratio. Importantly, this correlation is lower than the statistical relationship between stocks and bonds, at 0.28. We believe that this correlation shows that commodities could be another source of diversification in a portfolio of stocks and bonds. Over the past five years, commodities are more closely correlated with stocks than bonds.
Our View: The Four Tradeoffs of Commodity Investing
There are two main vehicles for gaining investment exposure to commodities: direct investment and equity investment. Direct investment in commodities for most people is a bit of a misnomer; most commodity investors are using futures contracts and typically do not take delivery of physical commodities. Futures contracts are preferable to some investors because the delivery and storage of physical commodities requires a lot of logistics and physical space, making it costly for investment purposes. However, this form of investing is distinct from purchasing the stocks of commodity-related companies, whose revenue and earnings are levered to commodity pricing. When deciding between these two investment types, we believe there exist four main tradeoffs that must be considered.
- Direct Investment Provides More Diversification. The first trade off involves the diversification effect of the investments. As can be seen in the table to the right, both physical commodities and commodity producing equites provide diversification benefits relative to stocks. While direct investments in commodities provide the lowest correlation (0.14) to stocks, it comes with its own set of drawbacks as discussed below.
- Unlike Direct Investment, Equity Investments can Provide Cash Flows. Since equity investments are in companies rather than the commodity itself, there is an associated cash flow with these investments that can be analyzed and potentially harvested. In particular, several of these companies return cashflows to shareholders both in the form of dividends and share buybacks, a feature we believe is particularly important in the current investing landscape. On the other hand, direct commodity investments are typically non-cash flow generating. For an investor that needs their portfolio to produce consistent income, this can be a major drawback to direct commodity investing.
- Direct Investments Through ‘Futures’ can be Complicated. One of the intricacies of direct commodity investing is that it must be done through the futures markets. In its simplest form, a future is the agreement to buy or sell a commodity at a specific price at a set date in the future. What makes futures investing difficult is the fact that futures prices can vary significantly from the current (spot) price of the commodity. In essence, the futures price may have already incorporated a significant rise (or fall) in commodity prices. Therefore, investing in commodity futures may not lead to investment success even if the investor correctly anticipated the direction of the spot price.
- Taxes and Structure can be More Complex for Direct Investment. Since direct investment is achieved using futures, there are tax complications regarding them. Traditionally, Exchange Traded Funds (ETFs) that provided direct commodity exposure require additional tax accounting. This solution can be costly for both the fund and the investor, and we believe should be avoided when possible. Recently, funds have begun to enter the marketplace which are able to avoid additional tax forms. To accomplish this, these funds must be domiciled outside the US and have historically paid out distributions at the end of each year. In addition to the intricacies of offshore investing, these distributions are taxed as short-term gains, making them hard for some investors to accept.
Implications For Our Portfolios
When considering the above tradeoffs, we believe it is important to also consider the context of current market conditions. As we discussed in our 2023 Outlook, we believe that this year will see a market that continues to transition from the era of ‘growth’ stock dominance to an increased focus on consistent cash flow, dividend, and coupon generators – what RiverFront calls the ‘P.A.T.T.Y.’ (Pay Attention to the Yield) theme. As such, the tradeoff of cash flows becomes the most important in our investment process. This results in our preference to invest in the stocks of commodity producing companies over direct commodity investing. Specifically, we believe it is important to identify companies in commodity sensitive industries that are capitally disciplined and have healthy balance sheets.
Risk Discussion: All investments in securities, including the strategies discussed above, include a risk of loss of principal (invested amount) and any profits that have not been realized. Markets fluctuate substantially over time, and have experienced increased volatility in recent years due to global and domestic economic events. Performance of any investment is not guaranteed. In a rising interest rate environment, the value of fixed-income securities generally declines. Diversification does not guarantee a profit or protect against a loss. Investments in international and emerging markets securities include exposure to risks such as currency fluctuations, foreign taxes and regulations, and the potential for illiquid markets and political instability. Please see the end of this publication for more disclosures.