"There's no way oil will never fall below $50."
"Gold will never hit $1000."
So many times in my career, I've heard extreme statements from investors and portfolio managers promising that commodities will never move above or below some arbitrary benchmark. A recent example of this often stems from the advent of electric cars, which if you believe the narrative, will supposedly eliminate the demand for fuel and thus oil. Yet, even Elon Musk has to laugh at this. After all, what do you think powers his SpaceX rockets? Pixie dust?
While it may be true that commodities do not have the same yield or inherent return as equities, this doesn't necessarily mean that they shouldn't be included in your asset allocation mix. In fact, the opposite is true given that, unlike most other holdings, commodities generally are not correlated to equities or bonds. For an example, look no further than the correlation between the Bloomberg Commodity index and the S&P500:
We believe in order to truly harness the advantages of commodities in a portfolio, investors must go one step further by using a tactical strategy. Being long on select commodities as they rise, in cash as needed, and short as commodities fall can often bring significant returns and lower your correlation to the market even further.
If you compare the Long/Flat Auspice Broad commodity index ("ABCERI") which takes this strategy and puts it into practice, using tactical long positions in rising markets and converting holdings into cash when markets falter, the correlation to S&P drops further when compared to a long-only index:
As you can see below, the portfolio benefits are obvious. Including ABCERI in a diversified portfolio may improve overall performance while reducing volatility and drawdowns. This example shows an 18 per cent improvement in annualized returns, 39 per cent lower drawdowns and 26 per cent less volatility.
So when is the time to add commodities? Timing is always challenging and commodities have been sliding for the better part of five to six years. However, as this chart shows, commodity versus equity values have long cycles and are at all-time lows.
Given there is never a specific floor, the value of commodities can always stand to fall further. Yet, they have recently become so stretched that we believe equity values are more at risk in the near term. In fact, as the following charts show, the recent performance of commodities is at the bottom end of its statistical distribution while equities are at the top.
At the end of the day, the world is still growing, and the developing Asian markets are not going away any time soon, meaning that the demand for fuel, food and materials aren't going to disappear overnight. In fact, demand may become greater than supply as the developed world shifts investment into technology-inspired resources, and funding becomes harder to come by for traditional commodities.
What many investors have to remember is that, unlike a stock which can literally disappear, commodities aren't likely to go bankrupt.
Now is a good time to look at commodities in any asset allocation mix. Consider ways to directly participate in commodities versus resource equity to reduce the stock market risk and beta. Look for tactical managers that specialize in commodity-tilted investments.
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