Commodities in Asset Allocation

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.

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About Geoff Considine

After earning his Ph.D. in Atmospheric Science, Geoff worked for NASA for 3 years, leaving to become a quantitative analyst developing trading and portfolio management solutions for an energy trading firm. In 2000, Geoff became a consultant focusing on quantitative methods in portfolio management. Geoff founded Quantext in March 2002. Geoff has published commentary and analysis in a range of publications. Quantext is a strategic adviser to Folio Investing. Neither Quantext nor Geoff Considine is an investment advisor and nothing in any content provided by Geoff Considine shall be construed as advice.

4 thoughts on “Commodities in Asset Allocation

  1. Dan Knight

    Though the case for adding commodities to a portfolio seems compelling, from the academic research and current institutional vogue, there are some subtleties to consider. First is the fact that most investors are getting their commodities exposure through futures contracts and not from the physical commodity. The research that supported commodities based their returns histories from the changing spot prices, not futures contracts. With commodities futures, there is the concept of contango, or negative role returns from one expiring contract to the next (vs backwardation, which generates positive role). This has been the predominant state of most commodities markets for many years, and thus hurting returns. The other “major” subtlety, is the huge influx of (primary institutional) investors into the commodities futures markets, changing the demand/supply nature of pricing. As institutions move enmasse in and out of asset classes, seemingly at the drop of a hat, the appealing correlations of commodities with other assets will appear ephemeral. I doubt that commodities will match their historic returns (and risks and corelations), going forward since in general they don’t offer any sort of fundamental return (coupon or dividend) and just a play on inflation expectations or supply/demand changes, which in general is efficiently priced into the spot. They offer a lot of volatility, with unproved, or worse, distorted return expectations.

  2. Geoff Considine Post author


    Great comments and thoughts–Thank you. There are problems with treating commodities investments as an asset class–for reasons that I allude to and for the issues that you raise–among others. That said, the research from Ibbotson suggests that commodities add value even with substantially lower expected returns than we have seen in the bull market caused by an increase in interest by institutions. The big problem for commodities is how hard it is to estimate expected return–as I note.

    Thanks for posting your thoughts.

  3. Geoff Considine Post author

    Thanks for your comment. PIMCO had Ibbotson do a really nice analysis of commodities–it is linked in my article. Ibbotson demonstrated a variety of ways to estimate expected returns and the value of commodities to a portfolio. There is no question that PIMCO has provided some of the thought leadership in making the case for commodities.

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