Higher inflation and a teetering stock market should spur advisors to think about diversifying client portfolios by adding commodities, investment experts urged recently. 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.

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

He pointed out 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 have been strong.

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.

Problems With Long-Only 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 (ABCERI) 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%.

Pickering said “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.”

Ginger Szala is executive managing editor of Investment Advisor. She can be reached at gszala@alm.com.