100% equity portfolios, 100% bond portfolios and 100% property portfolios are patently a thing. But you never hear investors talking about a ‘100% commodity’ portfolio.
Is a 100% commodities asset allocation a good idea?
Other assets classes are for your own protection
The general rule of thumb is that an investor should create a diversified portfolio that includes multiple asset classes. Just as picking 20+ assets from an asset class helps to mitigate the specific risks of each asset, picking multiple asset classes can further dampen the volatility of a portfolio.
Selecting investments purely from the commodity asset class (see here a full list of investable commodities) is a clear violation of this rule. Asset allocation is designed to enhance the risk v reward ratio. Specialising in a single asset class is therefore likely to increase absolute risk without a corresponding and proportionate increase in returns. That’s the theory.
Take a look at the prices of UK 10 year government bonds. While equities and commodity prices crashed in the shadow of the Lehman Brothers and other banking crises in 2008 – 2010, Gilt prices were buoyant. This is reflected in the downward slope in yields from 2010 – 2020. In fact, they delivered some of the largest capital gains on record to bondholders over this period.
A shakey business case
The business case for commodity investment is that you have forecasted the behaviour of supply and demand over a forward-looking period and believe that market prices for certain commodities will rise. You’d buy that commodity to capitalise on the anticipated price action.
What would you do if there were no compelling indicators suggesting that a commodity or group of commodities will rise in the near future? Would you be forced to sit in cash? It would no longer be a 100% commodity portfolio if that were the case.
But if you were forced to sit in commodities, wouldn’t that be tantamount to being in an investment with no upward business case whatsoever?
This thought experiment shines a light on one of the largest differences between buying shares and buying commodities. Shareholders understand that their underlying investments represent a growing asset. While market prices may fluctuate in value around its ‘true underlying value’, that underlying value is generally increasing over every time horizon.
In contrast, commodities don’t grow in size, quality or usefulness over time. Only environmental factors, such as market conditions, industrial development and fashions, will drive increases in the price. And these factors don’t overwhelmingly point to price growth.
Therefore an inherent flaw with a 100% long commodities portfolio is that few commodity traders actually believe that most commodities will rise in price over the long term. Instead, they are selective with their assets and their market timing.
A long portfolio that merely invests in commodities at day one and waits for ten years is, therefore, a very blunt object to engage with such a financial market. It’s entirely possible that after ten years, the gains in some assets are offset by the losses on others, and your account balance has barely moved either way.
The practicalities of owning commodities
Then we reach the practical question: how would a retail investor create and manage a real commodity portfolio?
There are a few options, although these become more limited if we aim for a ‘purist’ interpretation of the phrase.
- Private ownership
- Exchange-Traded Funds with physical holdings
- Exchange-Traded Commodities with an underlying commodity futures derivative
- Third-party company acting as custodian
The simplest option to understand is physical ownership, although this is only practical for precious metals. All other commodities have high volume and weight which makes it impractical to store. (Unless you have an oil silo in your garden?). Physical ownership brings risks such as loss to theft or damage. You would need to spend money on security precautions as well as insurance. These would all erode your portfolio value. There are many different ways to invest in gold bullion, but fewer options when it comes to perishable or high volume commodities.
Exchange-traded funds exist which invest in single commodities, although these are usually based outside of Europe as UCITS rules (which govern regulated funds in Europe) do not permit undiversified funds.
Examples include the SPDR Gold Trust ETF which is listed in the US. These ETFs provide a cost-effective way to access precious metals because the asset is owned and stored in bulk and therefore benefits from economies of scale. The SPDR Gold Trust suffers fees of just 0.4% to its fund sponsor, i.e. fund manager.
Problems introduced by the use of derivatives
Exchange-Traded Commodities offer a wider range of commodities because they are usually backed by derivatives or a simple IOU from a financial institution that promises to pay the ETC a return equal to the price movement on the derivative. But before you click away and pop ETCs into your portfolio, you’ll need to understand how each one works.
If the ETC invests in derivatives that have an expiry date, such as a forward contract or futures contract then you may find that the ETC exhibits different price behaviour to the underlying commodity price. That’s because holding derivatives with a long position on a commodity is not the same thing as holding the underlying. We can’t devote enough space in this article to explain the issue of contract rollovers but suggest you read this article instead.
The short summary is that an investor holding a long oil ETC over several years may be disappointed by the return of that product even if the underlying oil price gradually rises over that period.
Rather than buying and holding the asset, using ETCs can be equivalent to continually buying, selling, then buying back again. The risk is that where prices are rising upwards, the next contact to buy could be at a higher price than the sale price of the more recent contract. The ETC is losing out by churning through the contracts rather than benefiting from the entire upward movement in the price of the underlying.
What could a 100% commodity portfolio look like?
Here’s an illustrative example commodity portfolio:
- 15% Gold
- 10% Silver
- 10% Other precious metals
- 15% Oil
- 10% Copper
- 10% Cobalt
- 10% Coffee
- 10% Sugar
- 10% Cocoa
Overall, does a 100% commodity portfolio make sense?
In my opinion, a 100% commodity portfolio is an ambitious but risky folly. Commodities have a less compelling investment case compared to equities and corporate bonds. A diversified commodity portfolio would be expensive to hold (further tilting the odds against success) and impractical to manage. A commodity portfolio would also be exposed to counterparty risk and rollover losses if synthetic options like ETCs are used, which I think will be necessary to achieve a good level of diversification.