Investor enthusiasm for non-gold commodity ETFs[1] continued to wane during the first quarter of 2014, as net outflows accelerated to $922 million, following $1.785 billion in net outflows for 2013.[2] This is unsurprising in light of the poor performance of many commodity indices and their related ETF over the past few years. However, investors may be selling out of commodity ETFs at (or near) a stage in the business cycle when the diversification benefits potentially provided by commodities ETFs may be most beneficial.

In this blog entry, we’ll discuss how the relationship between commodity futures and the business cycle may provide a compelling reason for investors to consider adding commodity ETFs to a diversified portfolio of stocks and bonds.

In 2006, Gary Gorton and K. Geert Rouwenhorst published a study which compared the average returns of U.S. stocks, U.S. bonds, and a diversified portfolio of commodity futures during four different phases of the U.S. economic business cycle, based on the economic peaks and troughs identified by the National Bureau of Economic Research (NBER) from 1959-2004.[3] The four phases in the study were determined by bisecting each period of NBER-identified “expansion” and “recession”.

The data showed that both stocks and bonds tended to perform better during the first half of economic expansions than they did during the second half, while the opposite was true for commodity futures, which tended to outperform during the second half of expansions (Table 1).

Moreover, while stocks and bonds tended to produce negative returns during the first half of recessions, followed by positive returns during the second half, commodity futures tended to produce positive returns during the first half of recessions, followed by negative returns during the second half. Based on these observations, the study suggested that the long term diversification benefits offered by a portfolio of commodity futures were partly due to differences in performance during different phases of the business cycle.

During the most recent NBER-identified full business cycle, which began in November 2001 and ended in June 2009, there were important similarities and differences compared to the longer-term averages published by Gorton and Rouwenhorst. The most obvious differences occurred during the early expansion phase, as returns for commodity futures far outpaced stocks and bonds, and during the late recession phase, as negative returns for commodity futures were more extreme than the longer-term average, even as returns for stocks were alsonegative (Table 2).

Perhaps the most significant similarity between returns from the recent business cycle and the longer-term averages was the positive return provided by commodity futures during the first half of the recession, while stock returns were negative. Additionally, commodity futures outperformed stocks and bonds during the second half of the expansion phase, although the outperformance relative to stocks was less pronounced.

Of course, a major problem arises for those interested in applying a trading strategy to this information (which was recognized by the study’s authors): NBER identifies the beginnings and ends of recessions and expansions several months after the fact. This makes it impossible for investors to know when the economy has reached an inflection point between expansion and recession, or when a midpoint of either has been reached.