Are commodities the key to a smoother ride?

While the American public’s anger at rising prices is a major factor behind Trump’s return to the White House, Republican strategies are likely to add trillions to the national debt, further stoking inflation.

This matters because inflation worries the bond markets. US bond yields have already climbed, making mortgages and loans more expensive in a self-fulfilling spiral, and bond vigilantes are active across Europe as governments become more fiscally profligate.

• Invest with ii: Buy Global Funds | Top Investment Funds | What is a Managed ISA?

Sadly then, the era of high inflation won’t be reversed as easily as markets have assumed. For portfolio construction, this is important because higher inflation typically causes bond prices to fall, which is adding urgency to the need to rethink the traditionally diversified 60/40 portfolio of 60% in shares and 40% in bonds.

An alternative asset class to hedge against inflation  

Fund managers are therefore turning to commodities for their qualities as a hedge against inflation, their low correlation with equities and their potential for outperformance during times of geopolitical tension, which is possibly at its highest since the 1970s.

“In our experience, when inflation is elevated, and when bonds aren’t diversifying equity, commodities have done a good job as diversifiers,” says Anthony Rayner, fund manager, Premier Miton macro thematic multi-asset funds.

Rayner thinks inflation will reaccelerate in the medium term to levels that are uncomfortable for central banks. As a result, he says: “We are currently employing a blend of bonds and commodities to diversify equity risk. On top of this, commodities can be very effective at protecting against specific risks, such as geopolitical.”

Commodities far from homogeneous

For private investors considering the asset, however, there are big questions around which commodities to buy, how much of your portfolio to allocate and what products to use. For example, commodities are far from homogeneous, and 2024 has produced record levels of dispersion, with the spread year to date (as at early November) between top-performing Cocoa (up 157%) and bottom-performing Natural Gas (down 34%) standing at 191%.

• Sign up to our free newsletter for investment ideas, latest news and award-winning analysis

“Even within sectors, performance has been divergent,” says Robert Shimell, portfolio manager, diversified alternatives team, Janus Henderson.

Take the agriculture sector, where soft commodities are up and grains are down.

Shimell points out: “The breakfast basket commodities have gotten more expensive whereas key inputs into bread, pasta and baked goods have gotten cheaper. Cocoa, sugar, coffee and orange juice have all rallied due to supply issues, caused by adverse weather and crop disease. In contrast, wheat, soybeans and corn prices have fallen, on healthy supply and forecasts of record crop yields.”

A broad approach is best

Each commodity type behaves idiosyncratically as they are impacted by different factors, so the very best returns in any one year won’t be achieved by buying a broad basket of commodities. Nonetheless, a broad commodity index is the best bet, and indeed the only bet for a disciplined diversification strategy, as the basket has its own intrinsic diversification benefits, and investing in just a single commodity, particularly an industrial metal or foodstuff, is unquestionably high risk and could involve unknowable events and freak weather conditions.

• Sebastian Lyon video: why soaring gold is not yet a bubble
• Reasons why gold funds are flying

Research by WisdomTree looking at data since 1973 shows that an allocation of around 12% to a basket of commodities in a 60/40 portfolio, achieved by co-opting 12% of the bond allocation, would have made the same risk-adjusted return as the traditional 60/40 portfolio, but with better performance. They therefore argue that, even for a risk-conscious investor, adding some commodities will enhance portfolio performance. 

Moreover, WisdomTree’s research reveals that although commodities and government bonds have behaved similarly during deflationary environments and economic contractions, the two asset classes behave differently during inflationary periods and supply-side shocks such as the oil crisis in 1974, the financial crisis in 2008 and the pandemic – conditions which are more likely in the near-term.

Fund routes

Ways to gain broad exposure to this asset class include WisdomTree Enhanced Cmdty ETF - USD Acc GBP (LSE:WCOB) and L&G Multi-Strategy Enhanced Cmdts ETF GBP (LSE:ENCG). The former is one of interactive investor’s Super 60 ideas.

Both track broad commodity indexes but optimise performance by buying futures contracts. A futures contract is a legal agreement to buy or sell a particular asset at a predetermined price at a specified time in the future.

Both exchange-traded funds (ETFs) seeks to profit from futures contracts with high roll yields, profiting when one contract expires and rolls into a longer-term one that benefits from a higher spot price.

• Don’t be shy, ask ii…what’s the difference between Shell A and B shares?
• Are investors entering a new golden age?

Most private investors who are looking to back a single commodity choose precious metals such as gold and silver, which standalone insofar as they are largely prized for their value as a store of wealth.

“They have maintained their purchasing power over time,”  says Joe Lunn, investment manager, Jupiter Gold & Silver. “Gold measures the loss of purchasing power of the dollar, sterling and euro, not the other way round. Central banks are increasingly choosing to buy gold as a reserve asset, not US Treasuries.”

Other active fund options for commodity exposure include BlackRock World Mining Trust Ord (LSE:BRWM) and Schroder ISF Global Energy.

A potentially overlooked factor is hidden duplication within funds that may not appear directly correlated to commodities. For example, UK focused trusts JPMorgan Claverhouse Ord (LSE:JCH) and Temple Bar Ord (LSE:TMPL) have at least 20% exposure to mining and energy, because they have large holdings in British stalwarts BP (LSE:BP.) and Shell (LSE:SHEL).

Another route that some investors go down is to invest in commodity-producer companies – a hangover from the pre-ETF years when direct investment in commodities was neither cost-effective nor liquid. However, producer stocks behave like high-beta equities and do not deliver as much diversification or inflation hedging.

Striking the right balance

Investors must acknowledge, however, that commodities, unlike equities or bonds, do not generate cash flows, and so this part of your portfolio is less likely to grow. The challenge is therefore that, without a very disciplined and risk-conscious approach, investors may end up regretting their choices.  With hindsight, too large a holding, say 15%, might be lamented for forgoing growth potential by eschewing equities, while too small an amount, say 5%, might not do much to offset a crisis and keep the boat afloat.

“This fundamental characteristic raises questions about their efficacy as long-term investments,” says Stefano Amato, a fund manager in the multi-asset team at M&G Investments.

He notes: “For instance, the price of wheat today is comparable to its value five decades ago, illustrating the cyclical and often stagnant nature of certain commodities. This lack of intrinsic growth potential necessitates a strategic approach to commodity investment, focusing on timing and market conditions rather than a buy-and-hold strategy. The recent surge in interest surrounding gold is a case in point.”

• Is it time to come out of cash? And what to buy now
• Run your winners or take profits? How the pros decide

This is another way of saying that investors who are not just looking for diversification but also for decent returns from their commodity holdings, must keep abreast of developments, and there are an awful lot of stories to follow. With so many factors for an investor to assess, there is greater risk of a bad call.

For example, gold has been the headline act in diversifying against geopolitical tension, but if geopolitical risk is being driven by Middle East tensions, then of course oil tends to move higher on concerns over disrupted supply. Surprisingly, this year oil prices have remained rangebound.

Commodities, then, aren’t investments you can confidently tuck away and forget. Over the long term, there will be boom and bust cycles. You need only look at the MSCI World Metals and Mining index to see that four times in the past decade it has plummeted by more than 20% and soared by at least 30%.

“From a cyclical perspective, commodities tend to perform best late in the economic cycle when demand is strong and worst during economic recessions when demand is weak,” says Shimell. He adds: “On the supply-side it is cycles in commodity producer capital expenditure which drive medium-term supply, with periods of underinvestment typically leading to rising prices and vice versa.”

A final thought is that thematically there could be a long-term growth play in agricultural commodities, which are uniquely supported by the structural trends of tighter supply owing to increasingly volatile weather patterns and increased demand as populations grow and diets become more demanding.