As a way to compliment a traditional portfolio mix of equities and fixed-income assets, exchange traded fund investors should consider the diversification benefits of holding some exposure to alternative assets, like commodities.
"Commodities are key alternative investments that may offer diversification benefits for portfolio allocations through low correlations to other asset classes and its own sub-sectors," Maxwell Gold, Director of Investment Strategy at ETF Securities, said in a research note.
Investors should not overlook commodities as a critical component for a strategic, long-term portfolio component, especially in the current global landscape of evolving monetary policy, geopolitics and demographics, according to Gold.
Basic fundamental factors of supply and demand typically drive the commodities market, and this scarcity in addition, along with other factors like geopolitics and weather, tend to track global macroeconomic conditions closely. Moreover, many commodities are critical inputs for products and services we consume daily, which also make them highly sensitive to cyclical trends and inflationary trends.
More importantly, investors would enjoy the diversification benefits of commodities as the asset exhibit low correlation to traditional stocks and bonds.
"This low correlation stems from the fact that commodities are global assets driven by varying fundamentals," Gold said. "These distinct drivers lead to exposures beyond those factors offered from traditional financial assets like stocks and bonds."
When looking at three major commodity indices, the average 3-year correlation to a fixed 60% stock and 40% bond allocation is approximately 0.2 since 1979 - a zero reading would indicate zero correlation and a 1 reading would indicate perfect correlation.
"By incorporating a commodity allocation investors may reduce portfolio volatility and drawdowns while increasing risk-adjusted returns," Gold said.
Investors may also notice a historical link between commodity prices and inflation. During months when U.S. headline Consumer Price Index rises by 0.5% annually, all commodities rose 16% on average, with energy and agriculture/livestock among the top performers during inflationary periods.
Furthermore, as inflation is a key component of economic growth, investors can also capture this cyclical trend in portfolios with commodities given their high correlation to growth.
Investors interested in diversifying their portfolios with commodities exposure have a number of ETF options available to them. For instance, ETF Securities recently came out with a line of ETFs to outperform the widely observed Bloomberg Commodity Indices without the need to worry about troublesome K-1 forms come tax season, including the actively managed ETFS Bloomberg All Commodity Strategy K-1 Free ETF (NYSEArca: BCI), ETFS Bloomberg All Commodity Longer Dated Strategy K-1 Free ETF (NYSEArca: BCD) and ETFS Bloomberg Energy Commodity Longer Dated Strategy K-1 Free ETF (NYSEArca: BEF).
BCI tries to provide long-term capital appreciation that exceeds the performance of the Bloomberg Commodities Index. It may not invest in all the components of the benchmark but will hold similar interests to those included in the index, along with short-term investment-grade fixed-income securities, money market instruments, certain bank instruments and cash or other cash alternatives. The underlying Bloomberg Commodities Index tracks the price of rolling positions in a basket of commodity futures with a maturity between 1 and 3 months.
BCD tries to provide long-term capital appreciation that exceeds the performance of the Bloomberg All Commodity Index 3 Month Forward Index, which tracks movements in the price of rolling position in a basket of commodity futures with a longer maturity between 4 and 6 months.
Lastly, BEF tries to provide long-term capital appreciation designed to exceed the performance of the Bloomberg Energy Index 3 Month Forward Index, which tracks movements in the prices of rolling positions in a basket of energy commodity futures with a maturity between 4 and 6 months.
This article was provided courtesy of our partners at etftrends.com.