One of the bedrock principles of wealth management is diversification. Proper diversification can mean lower overall risk without lowering your portfolio’s potential returns. So alternative asset classes like commodities, which refer to everything from crude oil to wheat to gold, would seem to be a key tool in achieving this venerated idea of a fully diversified portfolio.
Yet commodities have been the worst-performing asset class so far this year, and their underperformance isn’t a short-term blip. Commodities have been trending downward for about 5 years and have fallen by more than 10% in 3 out of the last 5 quarters. Given these mediocre results, do commodities deserve a long-term allocation in your portfolio?
Unfortunately there’s not a simple “yes” or “no” answer to that question. Commodities don’t move in lockstep with more traditional investments such as stocks and bonds, so including commodities in a portfolio tends to increase the portfolio’s diversification. But commodities are also a very volatile asset class. Whether the additional diversification outweighs the high volatility depends on what else is in the portfolio and also what return commodities will provide.
Estimating what return commodities will provide, even over very long periods of time, is difficult. Since commodities are the inputs that go into producing the goods we use, it’s reasonable to expect commodity prices to rise roughly in line with the inflation rate over the long term. But commodity funds typically don’t hold physical commodities. They get exposure to commodities by buying commodity futures, which are financial products whose values are based on commodity prices.
Over the long term the returns from investing in commodity futures aren’t actually that closely tied to the changes in commodity prices. More esoteric factors, such as the difference between current commodity prices and futures prices and the returns from the bonds used as collateral when buying the futures, tend to be more important. In recent years, with the rise of commodity exchange traded funds helping to drive up futures prices and with the low interest rates that have persisted since the global financial crisis, the results from investing in commodity futures have been disappointing.
These two trends—strong demand for commodity futures from exchange traded funds and low interest rates—aren’t likely to disappear overnight, but they’re also unlikely to last forever. So at some point commodities will become a more rewarding investment than they have been in recent years. Yet given the intricacies of investing in commodities, making sure you understand exactly what factors will affect your investment’s performance is critical. Commodities can help diversify your portfolio, but in some cases the costs of that diversification outweigh the benefits.