Investors have long recognized the potential benefits of incorporating commodities into a diversified portfolio.

Commodities, which encompass natural resources such as energy, agriculture, and metals, can provide valuable diversification benefits due to their low correlation with traditional asset classes like stocks and bonds.

Additionally, commodities can serve as a hedge against inflation, as their prices tend to rise with increasing inflationary pressures.

Unlike stocks and bonds, which are tied to the financial performances of companies or government policies, commodities often move independently based on global supply and demand dynamics. This characteristic makes them an invaluable tool for risk management and inflation hedging.

However, gaining exposure to commodities can be challenging for individual investors. One popular approach is through commodity indices, which offer a convenient and cost-effective way to track the performance of a basket of commodities. Two prominent indices in this space are the Bloomberg Commodity Index (BCI) and the Goldman Sachs Commodity Index (GSCI).

The choice of indices for tracking commodity performance, such as the Bloomberg Commodity Index and the Goldman Sachs Commodity Index, can significantly influence investment outcomes.

These indices not only reflect the price movements of a diverse basket of commodities but also embody different methodologies and focus areas, which can impact investors' strategies.

The Role of Commodities in Strategic Asset Allocation

Strategic asset allocation involves setting target allocations for various asset classes and rebalancing them periodically.

In our strategic asset allocation strategies, we recommend an investment in commodities between 2 and 8% depending on the risk tolerance.

In our March-end active allocation recommendations, we suggested between a 2 and 3% allocation to broad-based commodity investments.

Commodities can play a key role in this setting by providing exposure to different economic factors and cycles. For example, during periods of strong economic growth, commodities related to energy and construction materials might perform well, while precious metals might perform better during economic downturns.

Benefits of Including Commodities in a Diversified Portfolio

Incorporating commodities into an investment portfolio offers several strategic benefits that can enhance both the performance and resilience of an investor's assets. Here are the primary benefits of including commodities:

Inflation Protection

Commodities are often seen as a natural hedge against inflation. As prices rise, the value of commodities typically increases. This is because commodities are raw materials that require more money to purchase as the value of currency decreases.

Historically, sectors like energy and agriculture have shown strong performance during periods of inflation, safeguarding the purchasing power of an investor’s portfolio.

Reduced Portfolio Volatility

Another significant benefit of commodities is their ability to reduce overall portfolio volatility. Because commodity prices often move independently of bond and stock markets, they can act as a counterbalance during periods when other asset classes are performing poorly.

This characteristic is especially valuable during market downturns, where commodities can provide stability and reduce the impact of losses. For example, in 2022 as both equity and bond markets were tumbling commodity indices exhibited double-digit positive returns.

The correlation of stocks and bonds to commodities has historically been low. In our strategic assumptions, we are currently using a correlation of 0.2.

Over the short term correlations can be quite dynamic. The chart below illustrates the correlation using a rolling 2-year window of weekly returns. Even with the recent jump in correlations, commodities play a significant role in lowering overall portfolio volatility.

One thing to note is that the reduction in overall portfolio volatility comes despite the generally higher volatility of commodities compared to, say, equities. The higher volatility of commodities is the main reason we limit our strategic asset allocations to a maximum of 8% of total assets.

Potential for Enhanced Returns (if you are skilled and risk-tolerant)

Commodities can also offer the potential for substantial returns.

For most investors, return potential should NOT be a consideration.

The primary rationale for holding commodities in a diversified portfolio is diversification/risk reduction.

But for those investors skilled at commodity investing and with a high tolerance for risk, the commodity space offers fertile ground for return enhancement.

Factors such as supply disruptions, geopolitical tensions, and seasonal cycles can dramatically affect commodity prices, providing opportunities for astute investors to capitalize on these fluctuations.

The most striking feature of the heat map of annual returns is the tremendous variation in annual performance. For example, over the last 3 years, silver prices are down 3.24% annualized while Live cattle prices are up 15.42%.

In general, there is more return variation among commodities than among more homogenous asset classes such as bonds and stocks.

Diversification Across Economic Cycles

Commodities respond differently to economic cycles compared to traditional equities and fixed-income investments.

For example, during an economic recovery, commodities related to industrial production and energy may see increased demand and price appreciation.

Conversely, during economic slowdowns, precious metals, often considered safe havens, may increase in value.

Comparative Analysis of Major Commodity Indices

Gaining exposure to commodities can be challenging for individual investors.

One popular approach is through commodity indices, which offer a convenient and cost-effective way to track the performance of a basket of commodities.

The Bloomberg Commodity Index (BCI) and the Goldman Sachs Commodity Index (GSCI) are two of the most widely recognized indices in this space, each with unique characteristics that cater to different investment strategies.

Bloomberg Commodity Index (BCI)

The BCI provides broad, diversified exposure to commodities.

It includes 23 commodity futures that are weighted principally on production and liquidity, ensuring that the index represents a true measure of commodity sector performance.

The BCI limits the weight of each commodity to a maximum of 15% and each group to a maximum of 33%, reducing the influence of overly dominant commodities like oil.

Goldman Sachs Commodity Index (GSCI)

In contrast, the GSCI is weighted more heavily towards energy commodities, which typically constitute about 60% of the index.

This makes the GSCI more sensitive to changes in the energy sector, potentially offering higher returns when energy markets perform but at the cost of higher volatility.

In terms of broad commodity sectors, the indices look quite different. The weighting of various commodities shown in the table below highlights the differences as of March 2024. The GSCI is, for example, much more heavily weighted toward Energy and less concentrated in the Metals sector.

Side Note: In our strategic asset allocation work, we usually recommend the Bloomberg Commodity index due to its lower volatility and broader nature.

Performance Comparison

Historically, the performance of the BCI and GSCI can vary significantly due to their different compositions and weighting strategies.

• Over the last three years, the GSCI has outperformed by close to 7% on an annualized basis reflecting the strong price appreciation of energy prices over the period.

• However, over a 5 to 10-year period, the BCI has outperformed by almost 1% per year.

The BCI's more balanced approach tends to provide more stability and less volatility, making it suitable for investors seeking a conservative commodity investment.

On the other hand, the GSCI's heavy emphasis on energy can provide excellent opportunities during periods of strong energy market performance but may require more active management to mitigate risks during downturns.

Nuances of Investing in Commodity Funds

Investing in commodity funds involves several nuances that can significantly influence the success of an investment strategy.

Commodity funds can vary widely in terms of structure, underlying assets, and investment approach, making it crucial for investors to understand these aspects before committing capital.

Types of Commodity Funds

Commodity funds typically invest in physical commodities, commodity futures, commodity companies, or a combination of these.

Funds that invest directly in physical commodities are less common and primarily focus on precious metals like gold and silver.

Most commodity funds invest in futures contracts, offering exposure without the need to handle physical goods.

Our preference at Retirement Juice is to invest in Exchange Traded Funds (ETF) offering index-like performance (i.e. passive exposure).

Risk Considerations

Investing in commodity funds comes with a set of risks unique to the commodities market.

These include price volatility caused by changes in supply and demand, geopolitical issues, weather conditions, and economic events.

Additionally, commodity futures can be influenced by the futures curve, where expectations of future prices can lead to contango or backwardation, affecting fund performance.

Management and Expense Ratios

Commodity funds are typically either actively managed or indexed.

Active management in commodity funds can provide the advantage of tactical asset allocation and hedging strategies which can protect against adverse movements in commodity prices.

However, this often comes with higher expense ratios, which can reduce overall returns.

Indexed commodity funds, on the other hand, usually have lower costs but offer less flexibility in responding to market changes.

Commodity investing carries higher costs than traditional equity and fixed-income vehicles.

Implementation Options

The universe of commodity funds is vast ranging from single commodity funds to broad-based vehicles designed to mimic an index.

In general, we suggest investors use a broad-based ETF vehicle in the asset allocation portfolios.

The main reason for this is our belief that the primary benefit of allocating to commodities is diversification/risk reduction vis a vie both stocks and bonds.

Our criteria for selection incorporate index construction considerations as well as cost.

Five funds that meet our criteria for investing in commodities are:

• iShares S&P GSCI CommodityIndexed Trust (GSG)

• iPath® Bloomberg Cmdty TR ETN (DJP)

• Aberdeen Blmb AllCmd ETF (BCI)

• iShares Bloomberg Roll Sel Brd Cmdty ETF (CMDY)

• iShares GSCI Cmd Dyn Roll Stgy ETF (COMT)

The Net Expense ratios of these funds are 0.75%, 0.70%, 0.32%, 0.29%, and 0.49% respectively.

The performance of these ETFs is presented below.

• Of note are the positive returns in 2022 when both stocks and bonds were in a bear market.

• Also, year to date all of these funds are in positive territory.

• Among our major asset classes, commodities as proxied by the energy-heavy GSCI index were up 10.1%, best overall even outdistancing the S&P 500.

• As of the end of April, the GSCI has outdistanced the performance of the BCI by close to 6%. This is mainly due to the acceleration this year of energy prices.

Asset Allocation Performance Review

High-Level Observations:

• All asset allocation portfolios we monitor are up year-to-date with higher-risk portfolios exhibiting commensurate higher returns.

• Conservative portfolios with a heavier allocation to bonds are still recovering from the 2022 capital market collapse but the trend is up.

• Over the last three years, the GF Low-Risk strategy is only up 0.8% on an annualized basis (before fees and transaction costs). Going back 5 years the annualized performance improves to 4.6%.

• Equity-heavy allocations have outperformed more conservative allocations thanks largely to the performance of US large-cap equities.

• The GF High-Risk strategy is up 2.6% on an annualized pre-cost basis over the last three years. Over the last 5 years, the strategy is up a respectable 7.6%.

• Year to date, commodities have provided a nice boost. A big reason is higher oil prices. Most recently, metal prices have joined the party providing a further boost.

Weekly Performance Attribution

Long-Term Asset Allocation Portfolio Characteristics

Expected Returns:

Risk:

Equity Risk:

A Bit of Humor Never Hurts

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