Almost every advisor with whom I speak recommends that clients’ portfolios have some exposure to commodities. The specific allocation varies with the usual factors: funds available, risk tolerance, time horizon, etc. The format varies, as well—some advisors recommend owing physical assets, like gold and silver coins, while the majority prefers financial instruments like ETFs and mutual funds.
The advice to include commodities may be ubiquitous, but it’s been difficult to find advisors who can cite a quantitative justification for their recommendation. When I ask about the portfolio research and analytics—published or internal—they use to justify commodities’ role, most advisors cite the standard qualitative arguments such as increased diversification, inflation protection, and so on. Very few can point to recent research that supports commodities’ role in clients’ portfolios.
RS Investments, a San Francisco-based investment management and research firm, provides a welcome quantitative analysis in their spring 2011 white paper, “Real Asset Strategies: Commodities vs. Natural Resource Equities.”
The firm contends that the fundamental case for commodities has changed since the late 1990s. Underinvestment in supply combined with increased demand from developing countries to significantly reduce many commodities’ spare capacity.
At the same time, the marginal cost of supply for most commodities began to increase. Consequently, RS Investments forecasts that “Future (supply) projects will require higher prices to generate economic returns, meaning that the incentive price needed for incremental production to meet incremental demand will continue to increase.”
From a long-term perspective, commodities have had negative or low correlations with other asset classes. That benefit has been reduced in recent years, according to RS Investments. For example, the correlation between the S&P GSCI and the MSCI World Index–All Markets is 0.28 for the trailing 20 years (through 12/31/2010). But that correlation increases to 0.50 for the last seven years and 0.6 for the past five years. The correlations have become even higher during down equity markets: 0.61 over seven years and 0.64 over five years.