In The Little Book of Commodity Investing (review to follow later in the week), Toronto-based portfolio manager, John Stephensen argues that commodities are a separate asset class and deserve a place in every portfolio. He cites two papers to support his viewpoint. The first titled Facts and Fantasies about Commodity Futures concluded that “fully-collateralized commodity futures have historically offered the same return and Sharpe ratio as equities” but the returns were “negatively correlated with equity returns and bond returns”. The other study by Ibbotson Associates titled Strategic Asset Allocation and Commodities also found that an equally weighted, monthly rebalanced composite of four commodity indices show “low correlations to traditional stocks and bonds, produce high returns, hedge against inflation and provide diversification through superior returns when they are needed most”. Mr. Stephensen goes on to say that his preferred route for investing in this asset class is through stocks of commodity-producing companies.

Whether or not you buy Mr. Stephensen’s argument, I wonder if Canadian investors should obtain even more exposure to commodities in addition to what they already own in the energy and materials stocks either directly or in their mutual funds. With energy and materials accounting for just 14.1 percent of the S&P 500 index, US-based investors may want to explore whether they should add commodities separately. But the weight of these two sectors in the S&P/TSX Composite index is more than three times as much at 47 percent and Canadian investors may already have too much riding on commodities. Even in a portfolio like the Sleepy Portfolio with just 20 percent allotted to Canadian stocks and 22.5 percent each to US and EAFE securities and a further 5 percent to emerging markets, the total exposure to the resource sector in the equity portion comes to 25.8 percent (18 percent of the total portfolio).

Canadian investors have a further problem. As hewers of wood and drawers of water, our economic fortunes (and therefore our wages, our home prices and other sectors of our economy) are already closely tied to that of commodities. It seems to me that putting even more eggs in the commodity basket may not be prudent way of managing risk.

This article has 23 comments

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  2. Since stock market returns have outstripped wage growth by a considerable margin (over the long run), I’m not clear on how commodities could have kept pace with equities. Perhaps it has something to do with the fact that the study starts the clock in 1959 which was near the start of a period of about 24 years of low stock returns.

  3. You are right that our economic fortunes are quite strongly tied to commodities already. I think the strength of our dollar is itself tied to commodities. So unless your personal net worth and income are underweight Canada, I would not suggest adding commodities in an attempt to diversify risks.

  4. You could also make the same argument about investing in foreign economies that do a lot of trade with Canada.

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  6. I think there’s a rationale for owning commodity stocks. I don’t own any myself because they are simply too volatile for my liking and as CC notes we as Canadians face embedded exposure to natural resources anyway but I think there’s a case all the same. What worries me are the commodity ETFs that are all the rage these days (e.g. DBC, GLD, etc). I see many retail investors blindly jumping into these products (for example, after reading a recent opinion piece in the Globe and Mail where a so called “expert” recommended DBC for the long term) with little understanding as to how they are priced and less than full appreciation about the fact that they (typically) don’t pay any distributions! For me, this is pure performance chasing. As unimaginable as it seems today, the bottom could one day drop out of the commodities market, and with it much of the chatter about the benefits of investing in commodity plays.

  7. Wow, talk about a timely post.

    I was just reading Roger Gibson’s Asset Allocation: Balancing Financial Risk. Perhaps the most notable info I got from the book is commodities’ low correlation to pretty much every asset class. This leads to reduced portfolio volatility and better compound returns. He demonstrates in the book how adding a clearly inferior asset class(worse returns or higher volatility or even both!) can in fact improve a portfolio if the correlation of said asset class is very low. The somewhat surprising part is that adding a most volatile asset class like commodities to a lower volatility equities portfolio can actually reduce the equity portfolio’s volatility. There is substantial gain in rebalancing as well. He really advocates commodities and REITs as fairly substantial parts of the equity exposure.

    Of course the book is written for the U.S. market and you bring up some very good points about differences from our Canadian perspective.

    My attempt to locate broad commodity ETFs over the weekend didn’t turn up anything too exciting. It seems the better alternatives are found as U.S. mutual funds, others are offered as ETNs which introduce unnecessary default risks. Fees look to be quite high as well.

  8. Canadian Capitalist

    @Michael James: Good question. The Ibbotson study calls it the commodity return puzzle and takes a stab at explaining why commodities had returns comparable to equities in their study period.

    @Houska: Agree. This chart shows the close link between our dollar and oil prices:

    @MoneySmarts: I can’t think of a foreign economy whose fortunes are very closely linked to ours. The US and other developed markets are so large compared to us that adding their stocks to our portfolios provides true diversification. I’m not sure that’s true of commodities.

    @DM: I think the arguments are strong that commodities deserve a place in our portfolios. The question is how much? For a US investor, Ibbotson suggests 25% for a moderate investor with about 20% in bonds. It would be nice to see some Canadian research on this topic.

    I agree that there is an element of performance chasing here. There won’t be any interest in commodities if they have been performing poorly. But given the recent returns in the commodity sector (which is one reason why the TSX has outperformed pretty much every other stock index), commodities are becoming interesting to investors. I wonder if this could turn out to be another instance of buy high.

    @GSP: I haven’t read Roger Gibson’s book. The Ibbotson study confirms that commodities have low correlation with pretty much every other asset class (Page 19). If this holds true in the future, adding commodities to a portfolio will have diversification benefits. But, I’m not sure if this also holds true for Canadian investors.

  9. The statistics that I have seen on the returns on commodities, over the past two decades or so, have generally shown that they exhibit lower expected returns and higher price volatility than equities. That being said, there is still a case for including them in a portfolio if their correlation with other assets in the portfolio is sufficiently low.

    Investing in a commodity index tracking fund probably makes the most sense for a typical investor that wants this exposure. These will typically just hold the most current futures contract and roll them over a regular intervals to avoid taking delivery.

    Be careful of the weighting of the underlying index. The Dow Jones UBS Commodity Index is weighted approximately 32% to energy, 33% to industrial and precious metals with the rest being split between agriculture products (about 29%) and livestock (about 6%). The S&P Goldman Sachs Commodity Index is heavily weighted towards the energy sector. It is made up of approximately 70% energy contracts, 11% precious and industrial metals, 14% agricultural commodities and 5% livestock.

  10. When I looked through the evidence and the debate it seemed there was on balance a good case for including commodities, in my case 5% of total portfolio. Combining commodities in fund introduces rebalancing and roll return. Since commodities includes more than energy and materials – notably agricultural products – and since commodity price doesn’t equate exactly to company success (exemplified by TSX energy and materials stocks) it seemed like a good bet for portfolio diversification, though what I did was reduce my Canadian equity allocation to make room for the new fund (DJP for now).

  11. I would approach commodities in the same way that I approach stocks. Which is… That I’m not willing to apply any “broad brush” statements about commodities as a whole any more than I would about equities as a whole.

    If I find a mining stock trading at a low P/E or well below their net asset value, then I would consider it a “buy” like I would any other equity. If I look at all of the straight commodity plays, I see a commodity like gold riding at a historical high and a commodity like natural gas sitting at a historical low. Take a wild guess at which one I’m buying! Psst, I’m a value investor.

    As others mentioned, the fact that we all have loonies in our pockets inherently means that we’re heavily exposed to commodities. It’s a fact of life – deal with it. If you don’t like that, then exchange your loonies for greenbacks or yen.

  12. CanadianInvestor, great info from some heavy hitters. The link to Bernstein’s article is mistakenly the same as the French Yahoo video, do you have the actual Efficient Frontier link?

    Are there any ETFs that mimic the DJ UBS Commodity Index? Only U.S. ones I see listed on the DJ site are from Proshare and not sure if those are longterm investor friendly.
    Wish we had access to the PIMCO CommodityRealReturn Strategy

    Still undecided on whether I’ll add some commodities to my portfolio. First I’d need to find a low cost way of doing so that doesn’t carry default risk(no ETNs). If I do decide to add commodities it won’t be for more than a 5% allocation and it will come from the equity portion of my portfolio. In the end, I doubt this decision will have much impact on my lifetime returns.

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  14. The research Stephensen refers to has been public for over 5 years. When it first came out, it was quite popular with investment managers, and they moved huge sums into the “new asset class” of commodities. Commodity index funds also have allowed retail investors to move large sums into commodity markets. The presence of these new kinds of investors has altered commodity markets. They are now subject to forces different from those in the periods covered by the research studies. So I wouldn’t necessarily expect them to behave or perform according to the study’s findings.

    • Canadian Capitalist

      @Larry: You bring up a very good point. I ran some quick numbers on correlation between DJP (Dow Jones-UBS Commodity Index ETF), EWC (iShares Canada ETF) and IVV (iShares S&P 500 ETF). The overall daily correlation between DJP and EWC since October 2006 is 0.80. Between DJP and IVV it is 0.75. That suggests a very high degree of correlation in the recent past. It is possible that markets have changed since those studies came out.

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