There's nary an industry expert who would argue against the long-term merits of having commodities in a balanced portfolio. A diversified basket of metals, energy and agricultural products has shown to improve returns and reduce volatility, while acting as an effective hedge against inflation. And there are various ways for advisors to get their high-net-worth clients such exposure: through hedge funds, partnerships, stocks, mutual funds, ETFs and ETNs.
Despite a recent sell-off that sliced about one third off a key benchmark, and the whipsaw effect of September's high-profile failures and bail-outs in the financial sector, commodities have been performing well for quite some time. According to the Standard & Poor's/Goldman Sachs Commodity Index (S&P/GSCI), commodities gained 15.80% over the past year through September 15. Five-year annualized returns were up 13.41%. And ten-year returns appreciated 12.38%.
Commodities have trounced the S&P 500, which was down 17.94% over the past year, up 4.56% per annum over the last five years, and returned 3.08% annualized over the past decade.
For the record, the S&P/GSCI benchmark comprises energy, industrial metals and precious metals, and agricultural commodities. It's weighted by global production. This means a heavy tilt toward energy, which currently makes up more than three-quarters of the index.
The basic question for advisors looking to help their clients jump in for the first time: Should they consider doing so during the current slide or wait until prices stabilize? At the same time, for those whose exposure has grown fat on the run-up, should they consider taking some profits off the table or let their positions ride?
The Case for Commodities
Before the current rally began, a recent report by the City of London Investment Management Group (IMG) recalled that commodities were in a 20-year-long funk. This was most evident in the collapse of market capitalization. Between 1980 and 2000, the broad-market industry weighting of natural resources declined from 35% to just 5%, according to S&P.
Then came a perfect storm of events, starting in the mid-1990s, that's been driving the current rally. The end of the Cold War opened up tremendous growth across Eastern Europe. Chinese and Indian demand for raw goods began increasing exponentially, and these countries were joined by a number of Latin American economies. Developed market demand surged following the recession of the early 1990s and again after Sept. 11, 2001.
A five-year sampling of spot prices by S&P through the end of 2007 shows that copper rose nearly 34% a year. Crude oil jumped by more than 25% annually. Wheat was up more than 22% a year. More volatile natural gas prices, which collapsed nearly 44% in 2006, saw more limited annualized gains of just 9.3%.
The second argument for commodity exposure comes from a 2006 study by asset allocation specialist Ibbotson Associates. It revealed that exposure to this asset class reduced overall portfolio risk while boosting total returns by more than a full percentage point.
Thomas M. Idzorek, CFA, director of research at Ibbotson and the study's author, tracked commodity performance from 1970 through 2004. Despite their sluggish state during the 1980s and 1990s, commodities generated the highest returns of all investments while being negatively correlated to all major asset classes. He also found commodities were positively correlated to inflation, thus making them a good hedge against rising prices.