The concept of adding commodities exposure as a way of reducing portfolio volatility may seem counterintuitive, but the main drivers of commodities prices often vary from those of other asset classes, particularly bonds and securities. This makes commodities important as both diversifiers and volatility reducers in a well-designed, risk-adjusted portfolio. Advisors and investors can turn to the commodities sector as a potentially effective means of achieving higher risk-adjusted returns in a portfolio.
Beta Vs. Alpha
The principles of "beta"1 and "alpha"2 have been much discussed in the world of modern portfolio theory, particularly by academics and statisticians. Fortunately, these concepts are widely understood and can often be utilized by professional money managers and ordinary investors alike as a method to potentially achieve improved risk-adjusted returns in almost any-sized portfolio. For purposes of this discussion, we will generally use the term "beta" to refer to the volatility of an investment in relation to the broader market, and we will generally refer to "alpha" as outperformance versus a comparable benchmark representing the broader market.
This article will not only explore the basic concepts of why and how commodities can be beneficial to a portfolio's risk (beta) profile, but also explore certain easily implemented beta optimization (alpha) strategies that may be able to improve results over time.
Why Commodities Work In A Portfolio
Why are commodities so popular? The answer is simple: Adding commodities "beta" in a portfolio can, over time, actually reduce overall portfolio volatility and even have a slight positive effect on overall absolute returns.
In the Morningstar study cited in Figure 1, by using a 28 percent exposure to a broad commodities basket in a 40 percent bond, 32 percent stock and 28 percent commodities-weighted portfolio, the volatility of the portfolio was reduced by 24 percent, from 11.6 percent to 8.8 percent. In this example, absolute returns actually increased slightly by 2.3 percent, from 8.7 percent to 8.9 percent (per year for the 20-year time period tested). Given this analysis, it is understandable why institutional investors have effectively utilized commodities in their risk-adjusted portfolios. Large institutions and managers can achieve this exposure through direct investments in physical commodities and through the retention of professional futures traders.
Fortunately for professional advisors and investors, the recent growth of the commodities-based ETP sector provides simplified access to a wide variety of commodities. There are several broad-based commodities ETPs offering access to baskets of up to two dozen (or more) different commodities, and there are single-commodity ETPs (excluding ETNs, which are backed by credit, not real assets) that represent 13 different commodities as of this writing.
Simply put, today's investors and asset allocators have a wide variety of commodities-based ETPs from which to choose when determining their investment objectives; all can be accessed directly through a normal securities account on major trading exchanges with no need for a futures account or external futures manager.
Investors face some basic choices when adding commodities-based beta to their portfolio. Primary among considerations should be the type of commodities exposure one wishes to achieve. One must ask if a broad-based, multicommodity basket is most suitable, or might exposure to a smaller, core group of commodities about which the investor has some knowledge be best?
Most important for investors to remember when choosing a commodities-based ETP is that no two benchmarks are alike; each has its own unique design and results will vary accordingly. Spend some time looking into the design of the ETPs in the commodities sector to find the one that best suits your investment needs.
Some multicommodity funds give investors equal weighting among a wide variety of commodities; others assign weightings to commodities according to their scale of global production or consumption rates. Many of the most popular of these indexes are heavily weighted in favor of a particular sector, such as the S&P GSCI, with its fairly strong concentration in energy. These funds allow immediate, generalized exposure to commodities and offer a convenient way for investors not currently familiar with commodities to gain initial core portfolio exposure.
In the single-commodity ETP sector, more narrowly focused products give investors the ability to custom-design or supplement their commodities exposure. These funds often appeal to investors wishing to overweight or underweight a core commodities holding, especially those investors familiar with specific commodities or sectors such as energy, precious metals or agriculture. Some of these funds are designed to efficiently capture short-term movements in the price of an individual underlying commodity; others may be designed for longer-term asset allocation exposure rather than for short-term trading results.
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