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Europe and the United States have been facing this situation for the last 12 months, with inflation indicators reaching decades-high levels. The availability of commodities has been affected by insufficient investment in production capacity, supply chain disruptions stemming from the global pandemic, and the war in Ukraine. These factors have seen consumers paying higher prices to obtain instant access to commodities.

An allocation to commodity markets can provide a differentiated source of return for investors, while also potentially improving their portfolio expectations. Let us explore why.

Over time, inflation has a devastating effect on the real value of money. In a rising inflation environment, cash loses purchasing power. The same can be true for other traditional asset classes, in which returns and cash flows may not keep up with inflation.

The values of stocks and bonds, for example, are tied to expectations of capital appreciation or changes in future cash flows. In contrast, the price of commodity futures is driven by shifts in the global supply of, and demand expectations for, raw materials. As a result, the historical risk and return characteristics of commodities have shown little or no long-term relationship with other financial assets, such as stocks and bonds.

Yet there are other assets that can help investors protect against inflation. What sets commodities apart is that they have historically offered one of the highest levels of correlation to unexpected inflation (see Chart 1).

Chart 1: Historically, commodities have offered the highest correlation to inflation versus other traditional and real asset categories

Historically, even a modest allocation to a basket of commodities within a traditional portfolio has helped to reduce overall volatility, especially during periods of extreme market volatility. From a portfolio construction perspective, this is both valuable and the reason why many investors hold commodities as part of their long-term strategic allocation model.

Commodities have also tended to perform well during periods of sustained high unexpected inflation risk (see Chart 2).

Chart 2: Annualized asset class performance during periods of six consecutive quarters of higher/lower-than-expected US inflation

(01.10.1981–30.06.2022)

There are different ways to invest in commodities, both directly and indirectly. Investing in physical commodities is impractical for most investors. Storing energy products, for example, oil can be complicated and costly, while other commodities such as wheat are perishable.

Futures contracts – standardized, legal contracts to buy or sell items at pre-determined prices in the future – can help simplify investing in commodities.

Contracts tied to individual commodities within major commodity indices are highly liquid and offer the ability to gain exposure to commodities. When investors buy futures contracts, they are expected to maintain a certain amount of capital, known as margin, in their brokerage accounts.

Investors involved in futures trading need to monitor these margin requirements and roll these contracts to a forward maturity date.

Managed futures accounts are another option for making indirect investments in commodities. These are a type of alternative investment vehicle that focus on futures and other derivative products. They are permitted to use leverage in the transactions that they make. In addition, they are allowed to go both long and short with the commodities that they follow, meaning that a successful strategy can produce profits in both bull and bear markets.

The benefits to investors are that managed futures accounts remove the hassle of investing directly in futures, and investments are managed by specialist investment professionals called commodity trading advisors (CTAs). These CTAs can help reduce portfolio volatility and offer greater capital efficiency through their investment experience.

The other option is to invest in a mutual fund, managed by an experienced portfolio manager. This mutual fund is benchmarked to a publicly observable index, which helps increase transparency, and benefits from exposure to a wide range of commodities. The manager can choose which financial instruments to use in order to represent exposure effectively.

An actively managed portfolio can potentially outperform its benchmark index and offer higher returns to investors. This is often the most practical approach for many investors who want long-term exposure to a basket of commodities for inflation hedging, as mutual funds provide built-in governance and reduce complexity.

Investors can also opt for an exchange traded fund (ETF) to gain exposure to commodities. ETFs typically seek to catch the return on major global commodities by tracking a commodity index. They are traded on a stock exchange and can be bought and sold like all stocks and shares. The return expectations on a commodity index ETF represent the return of the respective index, minus fees and expenses.

The final approach is to invest in commodity-related equities, such as mining companies or oil and gas corporations. The performance of these companies might not be directly tied to the performance of commodity price returns and can be negatively impacted by a company’s management and its hedging decisions, business execution risks, and the overall equity market environment.

Making a portfolio allocation toward commodities may offer diversification benefits along with opportunities to improve risk-adjusted returns. However, it is during periods of rising inflation when commodities become particularly useful.

The world is seeing the highest level of inflation in almost 40 years.³ What commodities offer is a potential way for investors to mitigate the effects of this inflationary environment on their portfolios.

Historical performance indications and financial market scenarios are not reliable indicators of future performance.

¹ Periods of higher or lower-than-expected inflation represent the change between the one-year-ahead forecast from the Quarterly Survey of Professional Forecasters (INFCPI1YR) and the Consumer Price Index (CPI, seasonally adjusted).
² 60 /40 represents a 60% S&P 500 TR / 40% BarCap US Agg. Bond Index portfolio; returns are rebalanced quarterly.
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