By Greg Liebl, CFA, Senior Investment Strategist
As the US economy has begun digging out of the massive hole left by the COVID-19 pandemic, ultra-loose monetary policy and several rounds of fiscal stimulus have awoken concerns that inflationary pressures may be just around the corner. In response to these concerns, more investors are considering an allocation to commodities, attracted to the asset class for its inflation-fighting characteristics. While the most common way to get commodity exposure is by investing in a portfolio of commodity futures, many investors believe that owning a portfolio of natural resource stocks is an easier solution. The logic behind this position is often that the largest driver of return for these stocks should be the price of their underlying commodity—for example, a mining company’s share price ought to be driven largely by the price of iron ore.
However, this seemingly commonsense argument couldn’t be further from the truth. For one thing, price movements of natural resource stocks display dramatically different return patterns than their associated commodity. For another, compared with an exposure to commodity futures, natural resource stocks demonstrate higher levels of correlation with the equity asset class while exhibiting significantly greater levels of volatility. Most importantly, they’ve historically been less sensitive to actual inflation. The result is that this intuitively appealing substitution of natural resources stocks for a futures-based commodity exposure leads to a less effective solution for both inflation protection and portfolio diversification.
Why do natural resource stocks behave differently from underlying commodities?
The notion that the shares of a natural resource company behave differently from the underlying commodity may seem puzzling. Why wouldn’t the price of copper, say, be the largest factor in the price movements of a copper producer? Yet there are fundamental differences between these two asset classes that cause their price levels to move independently. First, company-specific factors will influence an organization’s stock price but not the price of the underlying commodity. While stock prices will change to reflect company-specific changes in dividend policy, corporate governance, or earnings potential, there’s no reason to expect that this will have any impact on the associated commodity. For example, the Deepwater Horizon oil spill in the Gulf of Mexico in 2010 had a dramatically negative impact on BP’s share price due to many company-specific risks, including a change in management, fines imposed by the US government, and a revised dividend policy. But the oil spill had only a minor impact on the price of crude oil, which initially rallied following the incident as the market reacted to the negative supply shock.
Second, market-level factors that impact equity prices aren’t mirrored by commodity prices. These factors are categorically referred to as equity beta, which includes such things as the expansion or compression of earnings multiples, a negative regulatory environment for natural resource stocks, and the tendency for equity prices to move together as an asset class. For instance, during the onset of the COVID-19 pandemic in early 2020, general fear in the markets caused the price of the commonly followed NYSE Arca Gold Miners Index to decline over 25% through March 23. While a faintly similar return pattern can be detected in the price of gold, its return over the same period was a gain of 3%, with many investors actually fleeing to gold due to its perceived safe-haven status.
Third, many commodity-related companies are aware of their commodity exposure and may actively hedge away this risk using forward price agreements or other instruments. While this doesn’t completely immunize these companies from the price impacts of the underlying commodity, it diminishes the relationship between a company’s profitability—and, indirectly, its share price—and the price of the underlying commodity.
What does this mean for investors seeking diversification and inflation protection?
For many investors, the desire to own commodities stems from the asset class’s inflation-hedging or portfolio-diversifying characteristics. However, these positive attributes are somewhat lost when the allocation is expressed through public market equities due to the differences in price movements we’ve discussed. When compared with a futures-based commodity exposure, this return dispersion means natural resource stocks have demonstrated a much lower connection to inflation historically. Over the past 10 years, the S&P North American Natural Resources Sector Index’s correlation with the Consumer Price Index was 0.31, compared with 0.63 for the Bloomberg Commodity Index. In addition, natural resource stocks have demonstrated higher volatility and higher correlation with all equities when compared with commodities. The increased correlation with the equity asset class should hardly come as a surprise, since natural resource equities are—to state the obvious—equities.
Volatility and correlation properties of commodities and natural resource equities (12/31/2010–12/31/2020)
Sources: Bloomberg, S&P Dow Jones, Parametric, 12/31/2020. For illustrative purposes only. Not a recommendation to buy or sell any security. It is not possible to invest directly in an index.
Both this elevated correlation and higher volatility diminish natural resource stocks’ diversification benefit in a total portfolio setting. They can lead to a portfolio that has a lower expected return and higher expected volatility than an equivalent portfolio holding similar exposure to a futures-based commodity strategy.
The bottom line
Getting commodity exposure through a futures position is complex on many fronts, and it may involve investing in unfamiliar financial instruments that can appear complicated even to seasoned investors. For less experienced investors, the primary motive for choosing natural resource stocks to provide commodity exposure is the ease of implementation and a greater familiarity with the risk factors involved in an equity investment. However, this choice has serious downsides. At the top level, the very claim that natural resource stocks can be a proxy for commodities is questionable. Equity returns have many drivers that won’t affect commodity prices, and many of these natural resource companies use hedges to mute the impact of commodity price volatility on their revenues and profits. All in all, for an investor looking to add commodity exposure for either its inflation-fighting powers or its portfolio-level diversification, natural resource stocks simply aren’t a substitute for commodity futures.
Originally published by Parametric Porfolio, 4/26/21
References to specific securities and their issuers are for illustrative purposes only and are not intended to be and should not be interpreted as a recommendation to purchase or sell such securities. It should not be assumed that any of the securities referenced will be profitable in the future or will equal their past performance. All investments are subject to risks, including the risk of loss.