Despite historical price volatility for individual commodities – at least during the past decade – investors increasingly favor commodities in their portfolios.
According to the latest Institute for Private Investors Family Performance Tracking survey, 45% of respondents increased their allocation to commodities last year.
The reason? Commodities can add diversification to a broader portfolio, which can help fund retirement, estate and philanthropic ambitions.
Commodities – raw materials ranging from wheat to gold to oil – generally share two characteristics that make them valuable to a balanced investment portfolio. First, because commodity values historically are not correlated to other financial assets, they bring greater diversification to a portfolio.
Second, their values have correlated positively with inflation, a key threat to a portfolio’s long-term value. Investing in commodities can mitigate the risk of a gradual devaluing of a portfolio’s purchasing power. That’s because commodity prices are likely to reflect inflationary pressures, as they are the basic inputs into the global economy.
“When you add commodities to a broader portfolio, their low correlations with other asset classes can improve the portfolio’s risk-adjusted return, despite the fact that commodities by themselves can be very volatile,” says Pete Mladina, director of portfolio research for private clients at Northern Trust.
Adding Commodities to Your Portfolio
Key to choosing a strategy for adding commodities exposure is to take a long-term view in considering the portfolio, including the need for diversification.
“Total portfolio volatility is important, but what really counts for private investors is if this capital will be available to support lifestyle and retirement needs today and years into the future,” Mladina says. “From that perspective, lifestyle and retirement goals are exposed to significant inflation risk.”
While all commodities investments usually bear some measure of protection against inflation, each strategy carries a slightly different degree of protection. The most challenging factor is that the strategies with the greatest profit potential are least protected against inflation.
Mladina identifies four strategies that investors can use to add commodities exposure to their portfolios.
Futures contracts. Investors who purchase futures contracts – traditionally the most common strategy – agree to purchase a commodity in the future (at the “futures price”) and make an immediate investment of collateral. These investors hope to profit from the transaction in two ways: First, they bet the commodity price will surpass the futures price before the term of the contract concludes. Second, the amount they invest as collateral earns interest over the term of the contract.
Futures contracts have lost some of their luster in the current market, however, because each profit driver associated with futures contracts has largely dried up. The interest rates paid for collateral investments are far lower than their historical averages. These rates typically are close to the six-month Treasury bill rate, which currently is 0.15%, compared to its long-term average of 5.19%.
Further, historically, much of the appreciation of futures prices was due to backwardation, where the spot price (the current commodity price) was higher than the futures price and the investor earned a return premium as the futures price climbed to the spot price. Conversely, contango is when the futures price is higher than the spot price.
“Those two sources of return are currently very muted relative to history,” Mladina says.
Natural-resources equities. There are several ways to acquire commodities exposure without buying futures contracts. The strategy that may convey the most promising expected return is investing in natural-resources companies, with the idea that the value of a farming operation or mining company is tied to the prices of the commodities they harvest. Investors can earn a long-term equity return premium, but portfolios get a little less of the diversification benefit that drove investors to commodities in the first place.
To maximize the benefits of this strategy, Mladina says investors may wish to target upstream natural-resources companies focused on harvesting commodities – pumping oil, for example – as opposed to those that include value-added, downstream services such as refining or selling gasoline retail. These value-added services tend to mute the sensitivity of profit margins to the underlying commodities.
“Although natural-resources stocks are correlated to global equities in normal environments, historically they have displayed increased inflation sensitivity when inflation becomes a problem,” he adds.
Commodities ETFs. A third path to gaining commodities exposure is to buy the underlying commodities themselves. Commodities-based exchange-traded funds (ETFs) enable investors to purchase shares that represent raw commodities or a blended mix of commodities that function like an index fund.
Buying commodities ETFs is a better strategy than purchasing individual physical commodities, which generally offer no organic source of positive expected return and have embedded carrying costs.
Momentum. A fourth means of investing in commodities is momentum. According to the concept of a momentum premium, investors can identify certain past pricing trends that continue into the future. Mladina says the momentum premium exists across asset classes and is particularly meaningful in commodities futures.
But momentum is a unique source of return – one that is different than the broad commodities exposure most investors seek for their diversified portfolios. That’s because the fundamental bet is on momentum itself, not the underlying commodities exposure. The momentum premium is a diversifier, but one that is different than the conventional commodities exposure.
Tax Implications for Commodities
Before choosing to add commodities to an investment portfolio, investors must consider how tax law affects different types of commodities investments. A portfolio likely exists to be spent by the investor, his or her children, or his or her favorite charity. So it’s wise to consider expected commodity returns after all expenses, taxes and inflation.
One strategy that looks attractive from this perspective is buying stock in upstream natural-resources companies. That’s because returns from equity investments are subject to the long-term capital gains tax rate, at a maximum rate of 15% in 2012.
Compare that to commodities futures contracts, where returns are realized annually, with 60% of those returns taxed at the 15% long-term capital gains rate and the other 40% taxed at the short-term capital gains rate, a maximum rate of 35% in 2012.
Owning physical commodities isn’t any better. The Internal Revenue Service (IRS) treats those investments as collectibles, which currently are subject to a 28% tax rate.
Plotting the Best Course
Both commodities futures and upstream natural-resources stocks can play a role in diversified portfolios. Investors should consider the forward-looking return drivers and tax implications of the different approaches.
The choice of strategy also depends on the goals of the overall portfolio, Mladina says. For example, an investor may need to maximize the nearer-term diversification benefits of a portfolio with risk assets. Commodities futures contracts and commodities ETFs can play a role here.
Or, the investor may have a long investment horizon with long-dated funding goals that would benefit from the higher equity premium. This investor may prefer upstream natural-resources company stocks.
Regardless of the vehicle chosen, commodities exposure could improve the overall performance of an investment portfolio by potentially adding diversification benefits and mitigating inflation risk.