Who is buying commodities and why??

The world’s second largest and one of the most successful asset managers adds commodities in 2019!

The Vanguard Group has added the commodity asset class as a new offering for diversified portfolios. The fund is using the Bloomberg Commodity Index components (the institutional benchmark) with TIPS as collateral. The Asset Class has been on their radar for a number of years and in fact, the firm wrote an excellent white paper in 2010 making the case that commodities can be very effective in diversifying portfolios particularly when financial assets begin to lag.

The timing of this decision to add commodities in 2019, at this stage in the investment cycle, is the key takeaway. Not only is this their first commodity fund but, according to their web site, this is their only fund outside the equity, fixed income, money market and balanced categories! This is an excellent endorsement of the asset class in general and a strong statement that now  is the time for holding and/or adding commodities to diversified portfolios.

Their research analysis (Investment Case for Commodities 2010) went back more than 50 years and, in our opinion, came up with some noteworthy conclusions:

“Commodities futures have experienced long periods of significant returns for investors, as well as sequences of booms and busts similar to equities”

 “A historical analysis of commodities futures’ return patterns suggests there is little merit in the argument that relatively high long-term average commodities futures returns are solely a result of a few brief “abnormal” periods of high returns”

“Thus, during the late-expansion period (anticipating a recession), while equity markets tend to experience relatively poor returns, low inventory levels would imply that commodity futures are experiencing higher-than-normal returns. Further, because of inertia in inventories, it is not until a recession sets that commodities experience low returns. As stated, coming out of a recession, equities have tended to revive before the recession ends, while commodities futures returns have tended to improve only after the early expansion period has begun.”

Commodities historically deeply undervalued relative to equities; Does anyone still believe in reversion to the mean?

The degree that financial assets have outperformed hard assets (commodities) is by some measures, at a historic extreme. The following charts give investors a few ways to assess how extreme the diversion is between the price of commodities and the price of US Equites.

The ratio of the S&P GSCI (Commodities)  to the S&P 500 (U.S. Equities) has only been this low twice since 1970 and both were excellent times to add commodities!

The following table of annual commodity and stock returns gives an indication just how well commodities performed after the other two times the ratio was this low:

While equities and bonds hover near all-time highs, the average commodity in the RICI® remains approximately 50% below its highs since creation of the Index in 1998!

Conclusion and Opportunity

Reversion to the mean in portfolio management can be a powerful diversifying force. One of the most successful asset managers in the world is certainly making the case that now is the time to add commodities as a diversifier. The historical data certainly supports the case and commodities have exhibited excellent mean revision characteristics in the past. Investors have a historical opportunity to diversify a portion of their exposure to financial assets by adding raw materials at a time when commodity prices are extremely low and US equity and bond prices are at all-time highs.

The Rogers International Commodity Index®: A Global Demand-Based Portfolio

The RICI® is a composite, US dollar-based, total return index methodology. It represents the value of a basket of commodities consumed in the global economy, ranging from Agricultural to Energy and Metal products. The Index’s weights attempt to balance consumption patterns worldwide (in developed and developing countries) and specific contract liquidity. The value of this basket is tracked via futures contracts on 38 different exchange-traded physical commodities, quoted in four different currencies, listed on nine exchanges in four countries. The RICI® has significantly outperformed the Bloomberg Commodity Index since inception (8/1/98 through 6/30/19) as shown in the table below.

(To access additional management commentaries & reports please visit our web site for Financial Advisors and Institutions by clicking here. For further insights visit our Commodity Curve Blog.)

DISCLAIMER: The index returns shown above do not represent the results of actual trading of investible products, assets or securities. It is not possible to invest directly in an index. Exposure to an asset class represented by an index is available only through investable instruments based on that index and there can be no assurance that investment products based on the index will provide returns that are similar to the actual index performance or provide positive investment returns. All the indices referred to in this presentation above are not investable products and their returns do not reflect the fees and charges inherent in investing in a vehicle designed to replicate a particular index. Any index performance provided is for illustrative purposes only. The time period selected represents the inception date of the Rogers International Commodity Index® and is intended to provide a historical long-term average. Data provided by Bloomberg LP, BarclayMAP, and RBC Wealth Management. Past performance is not indicative of future performance.
Alan Konn

Partner & Managing Director of Price Asset Management