Should Commodities Be A Part Of Your Retirement Portfolio?

CATEGORIES: Investment Analysis

COMMODITY investingCommodities are relatively high-volatility assets that tend to have different trading patterns than equities. Because they have a “low correlation” to equities, commodities can be an important part of a portfolio’s diversification strategy. Should you be including commodities among your retirement investments?

What Are Commodities?

Commodities are the basic raw ingredients of our global economy. They include energy sources such as crude oil and natural gas, industrial metals like copper and zinc, gold and other precious metals, and agricultural products from soybeans to corn and livestock.

Typically when we invest in commodities, though, we are not investing in the physical assets themselves but rather in futures contracts derived from the value of the underlying assets.

Commodities funds – both mutual funds and ETFs – buy and sell futures contracts in various commodities. They manage the risks that investors would otherwise take on from investing directly in the futures contracts themselves.

The Economic Cycle

Why do commodities historically have low correlation to equities? The reason relates to the business cycle. Companies buy raw materials based on their economic forecasts; i.e. how much demand they expect in the coming months. These decisions usually lag economic reality somewhat. In other words, the timing of increased or decreased demand for commodities tends to be out of sync with a company’s level of earnings and its share price. Investors in commodities are, therefore, somewhat insulated from that phase of the business cycle when share prices tend to turn down.

Not As Exotic Anymore

Commodities used to be considered exotic instruments. They were out of the reach of most investors. That changed in the past ten years.

The increased availability and liquidity of commodities has had an effect on their correlation with equities. Consider, for example, that the average annual correlation between the S&P 500 and the Dow UBS Commodity Index, a popular commodities benchmark, was 0.31 from February 1991 to January 2013.

Correlation ranges from a maximum of 1.0 (perfect correlation) to -1.0 (perfect negative correlation), and the closer to 0.0, the less evidence of any causal relationship at all between a given pair of assets. The correlation 0.31, in other words, is pretty close to 0.0.

For the time period February 2008 – January 2013, on the other hand, the correlation between those same two indexes was 0.64 – more than twice its longer-term average.

Why the difference? One explanation is that, with commodities being so easily tradable via ETFs and mutual funds, they have become one of the so-called “risk on” assets that tend to trade up during periods of bullish sentiment, and that tend to be dumped in favor of Treasury securities or gold when market jitters set in. So commodities wind up being traded less on the basis of business cycle fundamentals and more on overall market atmospherics.

So Do I Still Need Them In My Portfolio?

Your retirement portfolio represents an investment for the long term. Despite the apparent increase in correlation between commodities and equities in the recent past, the historical business cycle relationship between the two asset classes is not necessarily broken.

A more likely assumption may be that the “risk on / risk off” patterns of the past several years might be based  on short-term factors that have dominated the post-2008 economy, and that will not be part of the long term landscape.

A healthy dose of commodities – maybe between 5% and 10% of a portfolio’s total value – should be a component of strategic diversification.

Do you own commodities in your retirement portfolio? Tell us what you think.

Find the commodities funds (ETFs and mutual funds) that make the most sense for you at Jemstep.com.

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About the Author

Katrina Lamb is a CFA for Jemstep. She has over 25 years experience in economics, finance, international development and management strategy, with a strong focus on global markets. She provides a voice of clarity, logic, and reason in an environment characterized by high uncertainty.

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