As investors look to growth in a post-vaccine world, exchange traded fund enthusiasts should consider the role commodities play under the cloud of accelerating inflation.
“Commodities may provide a uniquely valuable diversifying component to any long-term investment portfolio,” Ed Egilinsky, Head of Alternatives, Direxion, said in the recent webcast Inflation, Mega-Stimulus, and the Commodities Supercycle.
Egilinsky argued that commodities represent a significant portion of the CPI’s volatility, resulting in a positive and often out-sized response to inflation. Their low correlation to equity and fixed income can lead to enhanced risk-adjusted returns. Commodity markets offer unique active trading opportunities for capable investment managers to generate alpha.
Additionally, commodity demand could experience a shock due to post COVID “build back better” infrastructure spending in both developed and emerging markets. Tim Pickering, Founder, President and CIO, Auspice, believes that the extended period of underinvestment in supply and generational demand could both contribute to a commodity super cycle ahead.
The role of a weakening U.S. dollar could continue to support the commodities market head. USD-denominated commodities become cheaper for foreign buyers and weakness in the dollar and rising inflationary pressures could support hard assets as well. Egilinsky pointed out that U.S. political, fiscal, and monetary policies favor a weaker USD going forward. In addition, investor flows from overweight U.S. positions to more diversified equity exposure also favors a weaker USD.
Pickering also noted that the unprecedented M2 money supply growth to combat Covid-19 recessionary pressures has contributed to greater inflation risk.
Looking at the basic fundamentals, Pickering argued that favorable conditions for a move higher in commodity prices have returned. The Demand vs. Supply ratio is over 1.0 while prices are low, according to the Bloomberg Commodity Index. Global commodity demand is increasing while supply has not kept up in face of demand trending higher.
Egilinsky pointed out that historically, lower correlation has helped investors diversify a traditional portfolio mix. Specifically, commodities have exhibited a historically low correlation of 0.57 to equities, 0.03 to fixed income assets, and -0.70 to the U.S. dollar.
Many have focused on gold as a source of diversification and inflation hedge, but Pickering warned that the reflation trade has seen most commodities bid except gold.
“Historically a broad basket commodity exposure has been a better inflation hedge,” Pickering said.
Pickering highlighted the Auspice Broad Commodity strategy, which combines opportunistic commodity exposure with capital preservation. It takes an upside opportunistic while limiting downside based on observed momentum and trend within individual commodities. Consequently, the methodology is tactically invested by going long in rising markets, but it also exits positions to preserve capital as markets fall.
“We combine systematic long/flat positioning, dynamic risk management, and contract roll optimization to selectively participate in commodity gains while minimizing volatility and drawdowns,” Pickering said.
ETF investors who are interested in the strategy can look to the actively managed Direxion Auspice Broad Commodity Strategy ETF (NYSEArca: COM), which tries to provide total return that exceeds that of the Auspice Broad Commodity Index over a complete market cycle.
Financial advisors who are interested in learning more about commodity strategies can watch the webcast here on demand.