Higher inflation and a teetering stock market should spur advisors to think about diversifying client portfolios by adding commodities, investment experts urged this week. These economic factors, a potential bottom in the commodities price cycle, as well as the move of institutional investors into this sector, also are signs that portfolios should be adjusted to include this asset class.

“Commodities have been on a positive track since 2016, but people are frustrated in 2018 because the broad [commodity] benchmarks are stalled,” said Tim Pickering, founder, president and CIO of Auspice Capital, a Calgary, Canada-based investment firm, during a webinar held by Direxion discussing trade wars and commodities. “In fact the Bloomberg Commodity Index is down on the year, but all [commodity] sectors are not. There’s diversity in commodity sectors, and there are opportunities if you’re tactical.”

Pickering also noted that there is strong demand in agriculture and metals, “but due to political wrangling and tariffs that have been proposed … it has affected [base] metals and grains specifically [in the short term],” he said.

Indeed, the Purdue University/CME Group Ag Economy Barometer declined 26 points in July, falling to 117, making it the largest one-month decline in producer sentiment since data collection began in October 2015, according to the CME Group. This drop was predicated by the trade wars, according to James Mintert, the barometer’s principal investigator and director of Purdue’s Center for Commercial Agriculture.

“This summer we’ve seen tariffs placed on imports of U.S. ag products by China and Mexico that are impacting producers’ bottom line,” Mintert said in a statement. In fact, in a poll the Center took of producers on net income effects as a result of the trade war, more than two-thirds of producers indicated a loss of income due to the trade conflicts, and 70% of them expected a net income decline of 10% or more.

Mintert added that there was “real concern among producers that [agricultural prices] will remain low and, possibly fall even further.”

What’s the upside?

But these lows as well as a culmination of factors may be the reason investors should look at commodities — in a tactical way, Pickering said.

He points out that there is “huge global demand with protein meats. Soybeans [have been] hurt with tariffs, but wheat [prices] have gone [up].” He adds that although a sector as a whole might be down, there are specific commodities, such as wheat in grains, or cotton in softs, that are having up years. Crude oil prices also keep climbing, with the WTI futures contract close to $70 per barrel.

Pickering and his co-presenter, Edward Egilinsky, managing director and head of alternative investments for Direxion, both said demand in many commodities is exceeding supply, and should continue, especially with rising population growth in developing countries, and because it looks like the economic cycle of commodities is close to a low.

Egilinsky, whose firm develops and markets ETFs and mutual funds, noted that because of commodities’ low correlation to equities and fixed income, the fact they are a good inflation hedge and have an ability to generate alpha, “Commodities should be 5-10% of a portfolio,” he said.

But that doesn’t mean buy gold and call it a day. In fact, gold isn’t a substitute for commodity exposure, Pickering said, and “It’s a mistake” to think of gold as an inflation hedge. It’s the same as having only energy [in a portfolio]. Too much concentration doesn’t make sense.”

Problems With Long-Only

 “Commodity cycles run about 10 years,” Pickering said. “We believe we’re at the start of the cycle … strong demand, equity market level and a strong dollar [are also factors]. It’s a very exciting time for commodities if you go about [investing] in a tactical way.” Pickering’s team developed the Auspice Broad Commodity Excess Return Index, which was launched in October 2010.

Both speakers also noted the problem of long-only commodity funds, those that just buy and hold the various commodity indexes. For example, from 2008 to 2018, the annualized return of the S&P GSCI was -5.55, the Bloomberg Commodity Index was -9.34%, and the DB Commodity Index was -8.24%. Maximum drawdowns for all three during that time were more than 69%. Volatility is a key problem of adding these indexes to a traditional portfolio, Egilinsky said.

In fact, Auspice studied long-only commodity index funds and found there were four key problems with their index methodologies: 1) there was no ability to hedge during drawdowns, 2) there was a heavy concentration in certain sectors, thus poor diversification, 3) components of the index were rebalanced annually, so there was an inability to adapt to the changing price trends, and 4) it was predominantly static, that is long-only.

Due to these findings, Direxion worked with Auspice to develop the Auspice Broad Commodity Strategy ETF that is based off the Auspice Broad Commodity Excess Return Index, which the NYSE began publishing on Oct. 1, 2010.

Pickering says that the drive to develop this product was to be long commodities when they are moving higher and sit in cash or be flat when there is a drop or that market is too volatile. “We can do better being tactical, not necessarily short, but move to the sidelines [during market drops].”

Over the past eight years, the annualized return of the ABCERI was -1.14% with a maximum drawdown of -36.76%. In comparison, the S&P GSCI index return over that time period was -1.45%,  while its max drawdown was -64.25%. The BCI had an annualized return of -5.92%, with a maximum drawdown of -58.46%.

Pickering believes that “regardless at where we think we are in the business cycle, we do know commodities have been on the sideline and drifting lower, yet demand has come back … Overall we’ve seen a lot of money pumped into the stock market; that doesn’t mean I’m calling a top in it, but that money is looking elsewhere, I see that from an institutional perspective … and we’re being given a window right now where commodities should be considered.”