Commodities have shed their image as the sidelined asset class in recent years with tightening supply and strong demand boosting energy and metals prices, and investors increasingly seeking ways to diversify from traditional stocks and bonds.
The asset class has provided strong gains, and its role in strategic, long-term portfolio allocations is becoming more apparent amid shifting monetary policy, geopolitics and demographics. But as exchange-traded fund investors hunt for the right commodities for their portfolios, they may underestimate the importance of one particular step: choosing an index provider.
Not all commodity indices are alike—some, for instance, don’t provide significant, if any, diversification benefits—and investors should consider a number of factors before determining whether a benchmark has the potential to meet their objectives.
Commodities have recorded mixed year-to-date performance this year, with strong returns for metals but relatively weak performance for agriculture and energy commodities. Investors who opt for exposure to a broad basket of commodities can potentially dampen volatility through a diversification of assets. To gain that diversification, they should ensure they are not overly concentrated to a single commodity sector, such as energy, agriculture or metals.
Broad commodity indices vary dramatically in composition, with different sector constraints, exposures, and concentrations, unlike standard indices such as the S&P 500 or the MSCI World, or one offering exposure to a basket of fixed-income assets. The Bloomberg Commodity Index (BCOM), for example, has 31 percent in agriculture and 28 percent in energy, while many proprietary indices—as well as common benchmarks such as the S&P GSCI—have more than 50 percent concentrated in the energy sector. Forty percent of the S&P GSCI index is in oil, while other commodity indices allocate a maximum of 13 percent to a single commodity.
A diversified portfolio may help protect the investor from downside risk when a commodity ETF is added to a multi-asset portfolio. Investors should review the individual commodities within sectors to find the optimal sector mix, considering whether a fund or ETF includes both oil and natural gas, or one to the exclusion of the other, for example. Investors then need to determine how to best implement the individual commodities, such as through futures contracts, a proxy of equity companies or physical commodities. Investors who want to take a less passive approach could create a strategy that looks at short positions as well as long ones.
Commodities are key alternative investments that may offer diversification benefits for portfolio allocations through low correlations to other asset classes, and serve as inflation hedges for diversified portfolios. Investors may improve their portfolios by including broad commodities allocations, but central to their experience is how they implement choices of their exposure. Investors can essentially choose an ETF for pure beta replication, select different factors within an ETF for a more enhanced beta exposure, or opt for a more active approach with an outperformance strategy.
Prior to 2016, many investors remained skeptical about commodities after observing the bursting of the commodity “super-cycle,” which began at the start of the century. But last year was a turning point for the broad commodity complex, with the Bloomberg Commodity Index posting its first positive calendar year total return (11.8 percent) since 2010. And the role of commodities in society and the economy is continually expanding, as emerging economies boost global commodity demand and modern technologies transform commodity usage.
While sentiment toward the asset class has changed significantly, many investors are still unaware that ETFs can be a low-cost way to gain exposure to commodities, and that paying a little more attention to a benchmark could impact their returns.
Maxwell Gold is the director of investment strategy for ETF Securities, a specialist commodity exchange-traded product provider. He is a registered representative of ALPS Distributors, Inc.