EARLIER this month we saw the UK’s energy regulator Ofgem, raise the energy price cap. This sharp hike, which will take effect from April 1, comes just months after the last cap increase in October 2021, at which time there was a crisis at the petrol pumps which sent fuel prices soaring.
The steep rise in the prices of oil and gas has been part of a significant increase across the wider spectrum of ‘commodities’ over the last 12 months. This umbrella term covers a diverse grouping including industrial metals like copper and zinc, through to precious metals like gold and silver, and from livestock to agricultural produce such as corn and soybeans. In this week’s column we will look at the interesting role commodities play within a multi-asset portfolio, particularly in terms of diversification.
Given a decade of lack lustre performance, some investors have become frustrated with commodities as an asset class and called into question its usefulness in a multi-asset portfolio. While 10 years may possibly be too short a period of time to make such a judgment, it is true that the risk-return profile of commodities over the long term is not as attractive as for stocks or bonds when viewed in isolation. So then, what role do commodities play in a multi-asset portfolio?
The key here is that asset classes cannot and should not be judged in isolation, but rather in terms of the value they add to an overall portfolio. Including different asset classes and increasing the diversification of a portfolio can improve its risk-return profile. For example, let’s compare the classic 60/40 portfolio (60 per cent stocks and 40 per cent bonds) against an allocation including commodities (55 per cent stocks, 35 per cent bonds, 10 per cent commodities).
By simply adding commodities, we can reduce the overall risk in the portfolio, while the average return is the same. Investors can therefore seek to achieve a better risk-return trade-off when allocating some of their assets to commodities (noting of course that past performance is not a guide to future performance).
Let’s dig a little deeper by looking at how the different asset classes interact with inflation. We know that inflation plays an important part in shaping the macroeconomic environment, and as noted recently in this column it appears set to dominate policy makers’ minds throughout this year and beyond.
Stocks and bonds both have a negative correlation with inflation, meaning that when inflation increases these assets tend to fall in value. Commodities, on the other hand, tend to increase in value when inflation is accelerating, thus offering diversification benefits in high inflation environments.
Inflation is, after all, a measure of increasing prices of goods and services – therefore it stands to reason that the price of the raw materials (i.e. the commodities) used to produce these goods and services increases during periods of rising inflation. The opposite is also true, so that in times of falling inflation commodities generally under-perform. Of course, in a diverse portfolio, this would be offset by stronger performance of stocks and bonds in such an environment.
We strongly believe that diversified portfolios are the best way for investors to prepare for many different macroeconomic environments and not just the prevailing one. The last decade has been marked by historically low and stable inflation. However, as we have seen recently, a shift to a higher inflation regime can happen suddenly and quickly. A well-diversified portfolio is the best defence against such sudden changes.
Commodities play a useful role in multi-asset portfolios and adding them to a traditional blend of stocks and bonds can have important diversification benefits for (again we stress) long term investors. When investing it’s important to focus on the big picture and not to single out specific asset classes. We know it can be easy to get lost in the details, but what matters most is the performance of the overall portfolio, over the long term, to help you meet your financial objectives.
:: Mark Rooney is a wealth manager at Barclays Wealth and Investment Management in Belfast
