Wednesday, 16 November 2016

Previously we’ve discussed the benefits of a diversified portfolio. In this post we’ll focus on the Commodities asset class, which has some useful characteristics for developing a diversified portfolio.

Commodities include sectors such as industrial metals (copper, lead, zinc, and aluminium), precious metals (gold and silver), grains (corn and wheat), energy (oil and natural gas), livestock (such as cattle) and soft goods (like sugar and coffee). Often commodities are traded through futures markets at three, six or twelve month maturities. They are contracts to exchange money for real goods at some point in the future.

While there are a number of factors that influence asset class prices in general, growth and inflation are the most important determinants. As a result, asset class returns are mostly affected by changes in growth and inflation relative to expectations.

How asset classes respond to these factors is a key consideration in developing a diversified portfolio. This is where an allocation to commodities can be beneficial. Some of the characteristics of commodities include:

  1. diversification to equities and fixed income as commodities generally have low correlation to these markets;
  2. better inflation tracking as commodity prices tend to rise during periods of inflation. In fact commodity prices can cause inflation and this is a major risk to a typical portfolio made up of bonds and equities. They can also provide protection against a decline in value of the US dollar; and
  3. participation in global economic growth as growing commodity demand is a more direct way of capturing global economic growth.

It’s also critical to consider the correlations across commodity sectors when investing. While returns across sectors can vary from year to year, these correlations have historically been more stable. This provides a means to consider the risks of a commodities exposure when determining the allocation. Over time, an exposure across sectors is likely to provide improved risk-adjusted returns1 in comparison to an exposure concentrated in one or two sectors.

Another important consideration when investing in commodities is market volatility. Most of the fluctuations in commodity prices arise from the current demand-supply conditions and they react much more rapidly than equities or bonds to these types of pressures. So it’s important to establish what level of volatility is acceptable for portfolio construction.

Over the past few years commodity prices, in particular oil, have declined to a level that we believe represents better value. We also highlight that recently we extended our strategic asset allocation ranges for investing in commodities across QSuper’s multi asset class investment options2. In view of these developments, and noting the diversification benefits discussed above, we have a small allocation to commodities and continue to monitor valuations with a view to increasing the allocation as opportunities arise. We consider this approach prudent in the continued development of a robust, diversified portfolio.

1. Risk-adjusted return is a measure of the return on an investment relative to the risk of the investment, over a specific period.
2. This refers to the QSuper Lifetime and the Balanced, Moderate and Aggressive investment options.

The views of the author are not necessarily the views of the QSuper Board. We’ve put this information together as general information only and as such it doesn’t take into account your personal financial objectives, situation or needs. You should get professional advice before relying on this information.

Past performance is not a reliable indicator of future performance. Each of our investment options has a different objective, risk profile, and asset allocation.

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