Is Now the Time to Add Commodities?
Excerpted from the Fall 2010 issue of The Journal of Investing.
With the recent increase in equity volatility, commodity investments have garnered significant attention from investors. Previous research has found substantial benefits associated with commodity investments, but there remains considerable uncertainty regarding the consistency and general applicability of those benefits for equity investors.
In this article
- Interest in Commodities Up
- How the Study Was Conducted
- Tactical Allocations
- Tactical Allocation Versus Strategic Allocation
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We provide evidence that helps to resolve some of the uncertainty with regard to commodity investments. Specifically, based on a sample period of 36 years, we show substantial benefits to commodity investments regardless of the equity style an investor pursues. To obtain a significant benefit, however, requires a commodity allocation of greater than 5%. Interestingly, adding a commodity exposure enhances an equity portfolio’s return only during periods when the Federal Reserve is increasing interest rates, which is consistent with the belief that a major attraction of commodities is that they serve as an inflation hedge. Furthermore, an allocation to commodities in a tactical asset allocation using monetary conditions consistently outperforms both a strategic commodities allocation and an all-equity portfolio.
Interest in Commodities Up
Commodity futures have increasingly garnered interest as a viable component of individual investors’ portfolios. Much of the interest is attributable to research espousing the benefits of adding commodity exposure to equity portfolios. For example, three of this study’s authors—Gerald Jensen, Robert Johnson and Jeffrey Mercer (2000, 2002)—as well as Gary Gorton and Geert Rouwenhorst (2006) show that commodity futures returns are comparable to equity returns over long periods of time, and confirm that the contracts offer considerable diversification benefits due to their low (or even negative) correlation with equities. The low correlation appears to be driven by the unique performance of the contracts during inflationary periods. Since increasing commodity prices are typically one element of heightened inflation and higher interest rates, both of which tend to negatively affect equities, long positions in commodity futures are found to provide an inflation hedge for equity portfolios.
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Mitchell Conover , Ph.D., CFA, is an associate professor of finance at the Robins School of Business, University of Richmond.
Robert R. Johnson , Ph.D., CFA, is the senior managing director at the CFA Institute.
Gerald R. Jensen , Ph.D., CFA, is a professor of finance at Northern Illinois University.