A recent Wall Street Journal article discusses a growing movement among Target Date Funds (TDFs) to include an allocation to commodities. This article is notable not least because it gives a sense that the methods applied to retail investing lag well behind institutional thinking.
A lengthy analysis by Ibbotson from early 2006, for example, made the case for commodities–specifically commodity index exposure–as a valuable part of asset allocation. Their analysis suggested that portfolios representative of the kinds of risk levels taken on by individual investors would benefit from allocations to commodities of between 11% and 12.5%, even assuming modest future returns for commodities. Mohammed El Erian, head of PIMCO, proposed a model portfolio with an 11% allocation to commodities.
Some leading thinkers on asset allocation by individual investors follow a world view in which commodities end up with no place in asset allocations. This is quite a contrast to the institutional research.
Why might commodities improve a long-term asset allocation? First, there is a fairly low correlation between returns from commodities and returns from stocks. The correlation between the Dow Jones / AIG Commodity Index and the S&P500 is 54%, as compared to a correlation of 90% between emerging markets and the S&P500 and 94% between developed international stocks and the S&P500. Low correlations between assets in a portfolio lead to higher expected returns for a given risk level.
In addition to low correlation, commodities are also expected to provide protection from inflation. From a fundamental standpoint, inflation should broadly correspond to increasing prices of commodities.
My own analysis from 2007 comes to a fairly similar conclusion to Ibbotson in terms of the value of commodities as part of a strategic asset allocation. The model Target Date Folios made available by Folio Investing have varying allocations to commodities through ETFs, depending on risk levels at each target date, but they are on the order of 10% for portfolios with expected risk levels comparable to the S&P500.
The biggest question mark for commodities is how we estimate the expected future return. Ibbotson comes up with an expected return of 8% or so for a broad commodity index. Even when they dramatically reduce expected returns for commodities, they still find that commodities add value because of the diversification benefits.