The role of commodities in a multi-asset portfolio

There are different views on whether commodities should be included in a multi asset portfolio. We believe that they should be included: due to the specific way they react to growth and inflation, commodities can provide diversification relative to stocks and bonds.


Feb 5, 2017 | Scott Wolle

At the same time, however, we believe it is important not to simply track a conventional commodity index. Instead, the focus should be on commodities that are difficult to store, since such commodities are more often in backwardation than contango – and backwardation can lead to higher expected returns from commodity contracts. Also, when determining the commodity weight of a multi-asset portfolio, other components such as equities must also be taken into account.

Investors have long debated the wisdom of including commodities in a portfolio. Invesco’s Global Asset Allocation Team has a clear position: commodities belong in a portfolio, but not without the right plan. We summarize our research process feeding into multi-asset portfolios as well as a dedicated commodity strategy which we have been applying now for almost a decade.

The prevailing argument for including commodities in a portfolio relates to their inflation-hedging potential. Commodities have indeed demonstrated a strong correlation to inflation. Despite the declining relative importance of energy-intensive industries, this correlation has remained intact in recent years. Beyond simple pass-through effects of commodity price changes, most observers link the effect to some combination of monetary policy (i.e., increases in money supply lead to increases in commodity prices) and changes in inflation expectations.

The link between commodities and inflation also helps to explain the second benefit often attributed to commodities: their diversification potential relative to traditional assets such as stocks and bonds. Stocks and bonds should respond in opposite ways to changes in real growth. But both tend to do poorly in conjunction with rising inflation, at least in the short-term, whereas commodities tend to do well.

Commodities and investment returns
One would think that several decades would be sufficient for practitioners and academics to agree on whether an asset should deliver positive excess returns over the long term. But, no such agreement yet exists for commodities, with even some relatively recent papers debating the asset class’ merits.However, at its core, commodity investing relies upon the central tenet of any successful investment strategy: buy low, sell high.

Backwardation, a phenomenon characterized by further-dated commodities trading at a discount to the current spot, represents one of the most appealing and direct applications of this simple concept. In the absence of any forecast, prices should naturally rise to the spot level as the investor moves forward in time. Specific situations may make holding the more dearly priced contract the more attractive option, but most traditional investment strategies will always favour the purchase of the discounted asset.

In 1930 Keynes coined the term “normal backwardation”. Subsequent research has clearly proven that backwardation is not normal for most assets.2 These assets trade in contango, where the more distant asset trades at a premium to the spot price, and therefore tends to cause investors to buy high and sell low. Some investors find this set of facts – most assets trade in contango on average, and contango often generates negative returns – sufficient to avoid the asset class. We believe that this ignores the potential return that is equally clear from the research.

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1 Gorton, Gary and K. Geert Rouwenhorst. "Facts And Fantasies About Commodity Futures," Financial Analysts Journal, 2006, v62(2,Mar/Apr), 47-68; Erb, Claude B. and Harvey, Campbell R., The Tactical and Strategic Value of Commodity Futures (January 12, 2006). Available at SSRN: abstract=650923
2 Cp. Kolb, Robert W (1992): Is Normal Backwardation Normal?, Journal of Futures Markets 12(1), pp. 75-90.