When investing in the commodities market, exchange traded fund investors should understand how the underlying market works to best diversify an investment portfolio and optimize potential returns.
On the recent webcast, The Evolved Commodity ETF Landscape and Diversification Benefits, Kevin Baum, vice president and senior portfolio manager at Invesco PowerShares, points out that commodities act as a diversifier to traditional asset classes. Specifically, over past 15-years, commodities have shown a 0.03 correlation to U.S. bonds, 0.38 correlation to U.S. equities and a 0.51 correlation to developed markets – a 0 reading would correspond to perfectly uncorrelated assets while a 1 reading reflects perfectly correlated assets.
Consequently, since commodities help dampen a portfolio’s volatility, an investor with something like a 48% equity, 32% bond and 20% commodity portfolio would have generated an improved absolute and risk-adjusted return than a portfolio of just equities or one with the traditional 60/40 equity/fixed-income split, Baum said. According to a recent ETF Trends and RIA Database survey, most financial advisors are also looking to increase their commodities positions next year.
Moreover, once inflation picks up, commodities will act as a good portfolio hedge and potentially outperform equities and fixed-income. Specifically, commodities show a 0.32 correlation to inflation, whereas U.S. stocks h ave a 0.09 correlation and bonds have a -0.18 correlation. The inverse bond correlation makes sense since higher inflation would translate to lower real returns for bonds.
Baum also argues that as we shift into the later stages of a market expansion, commodities will outperform. During the eight business cycles from 1959 to 2013, equities and bonds generated an average 14.5% and 8.6% return, respectively, while commodities rose 6.0%. However, during the late expansion period, commodities outperformed with a 22.7% return, compared to equities falling off 1.7% and bonds rising 1.0%.
“Strong commodity performance has historically followed strong equity markets,” Baum said.