Do commodities really offer diversification?

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New products in the exchange traded industry have allowed investors to access a broad spectrum of natural resources effectively and cheaply.

From the most recognised commodities such as gold and oil, which together account for 2.8 per cent of the global ETF industry, to foodstuffs and industrial metals, natural resources have become ever more popular as alternative asset classes.

Commodities are held for a variety of reasons, chief among these their merits as real return assets able to provide a hedge against inflation and the diversification benefits they can bring to multi-asset portfolios in improving the risk-return profile.

Having a high correlation to inflation is self-explanatory; commodities can protect portfolios in the event of surging prices. Yet even in today’s world of disinflation and exceptional monetary stimulus, a zero/sub-zero interest rate environment is giving precious metals renewed reason to shine.

They have also traditionally had a low or negative correlation to other assets, such as equities, fixed income and cash. It means investors have used individual commodities to provide an alternative source of returns that will work differently depending on what stage of the investment cycle markets are in.

The diversification benefits of adding specific commodities to portfolios are complex. While they can offer diversification at certain points, this is very much down to the precise nature of the exposure and to the exact point at which the commodities are purchased, and it is by no means guaranteed they will do so.

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Oil, for example, has moved very closely in line with US equity prices in recent months, des-pite the previous assumption that a falling oil price would boost consumer spending and economies and support equity markets. Indeed, at the start of this year Brent crude and the S&P 500 neared a perfect correlation reading of 1.

It is not just the US. Other markets around the globe are also moving more and more in tandem with the oil price. In this environment, oil’s ability in the short term to reduce investment risk through diversification is clearly challenged.

The broad commodities spectrum is notably more influential at bringing diversification benefits than either single commodities or individual sub-groups of commodities. This is because indexes such as the Bloomberg Commodity Index combine a broad and diversified basket of largely uncorrelated commodities that in aggregate create a significantly lower overall volatility profile. As can be seen in the cross-correlation matrix below, correlations between assets within sectors such as energy are high, but across the portfolio correlations tend to be very low.

In terms of absolute volatility, a broad basket of commodities can also exhibit much lower volatility than single commodities.

That is not to say there are no advantages to owning a single commodity within a portfolio. Single ETPs exposed to gold or oil, for example, allow investors to express a specific and strategic view without exposure to other commodities on which they may have a negative view, or no view.

Should an investor have a particularly bullish or bearish view on a commodity then leveraged (short) ETPs can be used to potentially double or treble the return delivered.

In an ideal world, investors would allocate to an asset at the bottom of its cycle every time, and sell out at the peak. The reality is very different and when dealing with investments as volatile as commodities, it may make sense for investors to hold a broadly diversified portfolio. This allows them to benefit from broader trends and minimises the price volatility within their portfolios.

Viktor Nossek is director of research at WisdomTree Europe