Bloomberg Professional Services
This article was written by Jim Wiederhold, Commodity Indices Product Manager at Bloomberg.
Equities have enjoyed one of the best recent 20-year periods in history, only falling in 3 calendar years since 2003. The cumulative increase over this period is over 5X. With equities at elevated levels, now may be time to add diversification to a portfolio through a commodities exposure.
Asset class performance is a key determinant for deciding how to allocate within a portfolio. Recent performance tends to garner more importance in determining what to keep in a portfolio, what to take out, and what new exposure to add. This decade, performance of commodities has shown the 2020s have been a good time to hold commodities exposure, and that doing so contributed meaningfully to portfolio returns. In 2021, equities and commodities both rose 27%. In 2022, commodities rose again by 16%, while equities fell 20%. These disparate returns illustrate the diversification benefits, and volatility—dampening aspects, of a commodities allocation. Historically, commodities prices tend to move much more dramatically to the upside then to the downside – taking the elevator up and the stairs down.
Equities and other asset classes tend to rise much more slowly over time. In some instances, like the last quarters of 1987 and 2008, equities can fall with high volatility. Looking at data over the last 60+ years, the most extreme upside moves for the Bloomberg Commodity Index (BCOM) were more amplified than downside moves for the commodities asset class (Exhibit 1). The average top 10 positive years for BCOM were more than 2x more powerful than the average top 10 moves to the downside. Surprisingly, the average for the top 10 downside years for BCOM was right in line with the average for the top 10 worst years for equities.
For equities, the average upside of the best years was 70% of the upside seen from commodities. When volatility picks up like we’ve seen so far in the 2020s, the price performances of these two asset classes tend to diverge. Some of the best years for commodities in the 1970s corresponded with some of the worst years for equities. Commodities prices can shoot higher, while the most extreme downside moves (roughly -20%) are in line with the most extreme equity downsides moves. This can be attributed to the notion commodities prices are not forward-looking like equities and reflect the current supply/demand balances at play in the present. When information changes drastically which tends to be new news regarding geopolitical uprisings, weather related supply issues, or unexpected new demand drivers, this changes the current situation for commodities and prices typically rise to meet current supply/demand imbalances. Surprisingly when looking at all prices moves during this period, commodities averaged at worst only -17% average downside quarterly performances while equities averaged -19%.
Commodities have been known to be one of the more volatile asset classes, but over the last year, commodities’ volatility has mostly been in line or below that of equities (Exhibit 2). Commodities could potentially lead to more upside performance for a portfolio based on how the asset class historically outperforms without increasing a portfolio’s risk profile.
When commodities prices shoot higher, it tends to be unexpected and outside of most forecasts (due to the fact prices reflect the current supply/demand balances as discussed earlier). This implies that to benefit from these unexpected price appreciations, you need to hold a long exposure continuously. There are ways to hold exposure with a reduced negative roll yield impact over time by looking to commodities indices like the Bloomberg Enhanced Roll Yield Index (BERY) or the Bloomberg Commodity F3 Index (BCOMF3). Theses versions are situated on different points on the commodities futures curves and tend to allow a market participant to hold a long commodities exposure over time and in some cases capture a positive roll yield. Regardless of the broad commodities expression used, the underlying traits for all commodities indices is they can provide diversification and inflation hedging when used in a portfolio. Prudent portfolio management involves adjusting allocations according to changing market themes and dynamics and the tailwinds for commodities markets now should be considered when thinking about portfolio diversification.