Commodity Basics: What are Commodities and Why Invest in Them?

Commodities are the raw materials that producers use to create the goods that people buy and the food that they eat. Taken together, commodities form an asset class—similar to stocks and bonds—that can diversify a portfolio and provide a hedge against rising inflation. In the past, commodities have typically played a small role in portfolios because it was difficult to gain broad exposure to the asset class. However, that may change with the development of products that track indices covering a wide range of commodities, thus offering investors the potential advantages of greater diversification within the asset class. Investors should continue to note that commodities are volatile investments and should only form a small part of a diversified portfolio. Commodities may not be suitable for all investors.

Just to name a few, commodities include agricultural products such as wheat and cattle, energy products such as oil and gasoline, and metals such as gold, silver and aluminum. There are also “soft” commodities, or those that cannot be stored for long periods of time, which include sugar, cotton, cocoa and coffee. The key difference between commodities and financial asset classes such as stocks and bonds is that commodities are tangible, physical assets that can be “used” for something. A gallon of gasoline can be bought, sold or used to power a car. A stock or a bond is a piece of paper representing a claim on some future cash flow and cannot be used for much else. This is an important difference because it affects the way that commodity prices react to changing economic conditions.

Commodities Are One of the Few Assets That Benefit From Inflation

Most assets do not benefit from rising inflation, particularly unexpected inflation, but commodities usually do. As demand for goods and services increases, the price of those goods and services usually rises as well, as does the price of the commodities used to produce those goods and services. Because commodities prices usually rise when inflation is accelerating, investing in commodities may provide portfolios with a hedge against inflation.

By contrast, stocks and bonds tend to perform better when the rate of inflation is stable or slowing. Faster inflation lowers the value of future cash flows paid by stocks and bonds because those future dollars will be able to buy fewer goods and services than they would today. For example, during the 1980s and 1990s, inflation fell and stocks and bonds experienced bull markets.

Commodity prices had their ups and downs during the 1980s and 1990s, but ended the period at roughly the same level where they began, due to a combination of factors. For one, there was less demand for commodities as a hedge against inflation, which was falling. Also, consumer spending in the U.S., which dominated global demand during the period, shifted towards services that require fewer commodities to produce than manufactured goods.

Commodities and financial assets are also likely to react differently to rising inflation, particularly if it is unexpected. For example, a higher rate of inflation could raise interest rates and corporate borrowing costs, weighing on both stocks and bonds, while increasing demand for commodities as a hedge against inflation.

Also, inflation typically occurs in periods of faster economic growth, when demand is rising for the goods and services created from commodities. Higher demand for finished goods and services would usually boost the price of commodities as well, particularly if demand were increasing in developing regions of the globe where there is greater need for things like refrigerators and cars that require a lot of commodities to produce.

Commodities may also react differently from stocks and bonds to other changes in economic or market conditions. For example, if OPEC unexpectedly reduced the supply of oil by a significant amount, the price of oil, gasoline and heating oil would likely rise. Natural gas prices might rise as well if industrial consumers switched from oil to gas. Rising energy costs could lead to higher commodity prices overall, which would presumably weigh on corporations’ bottom lines and possibly result in inflation that would weigh on bonds. Commodities may also provide a hedge against other “event risks,” a catchall phrase meaning the risk of war or other geopolitical event that could cause other assets to fall.

The table below illustrates the fact that commodity returns have been largely independent of stock and bond returns, but positively correlated with inflation. Since January 1990, quarterly returns on the Dow Jones AIG Commodity Index (DJ-AIG) have been negatively correlated with both the S&P 500 and the Lehman Brothers Aggregate Bond Index (LBAG), and positively correlated with both the CPI and the quarterly change in inflation.

Correlation of Quarterly Returns (1/90—3/04)

Source: Bloomberg Financial Markets and Bureau of Labor Statistics

This table is not indicative of the past or future performance of any Allianz Global Investors product.

Why Invest in Commodities? Diversification.

Because commodities are distinct from financial assets and react differently to changing economic conditions, commodities can diversify a portfolio of stocks and bonds. In a diversified portfolio, assets do not move in sync with each other, which limits the volatility of the portfolio. Lower volatility reduces portfolio risk and should improve the consistency of returns over time. Because of its potential to reduce risk while improving returns at the same time, diversification has been called the only free lunch in investing, and it is the primary reason for investing in commodities.

Despite the potential diversification benefits of commodities, most investors stick to financial assets in their portfolios because stocks and bonds have traditionally been easier to invest in and commodities can be volatile. However, the development of products that track a broad index of commodity futures should make it easier for investors to reap the diversification benefits commodities can provide.

As a rule, individual commodities or even the asset class itself would be too volatile to be the only asset in a portfolio—few investors would consider this anyway—so the volatility of commodities should be considered from a portfolio perspective rather than separately. In a portfolio setting, the volatility of commodities, stocks and bonds should complement each other because these assets do not move in tandem with each other.

In other words, volatility in an asset class that is not correlated with the volatility of other assets in a portfolio is a key source of diversification. However, the diversification benefits of commodities can be significantly undermined if the portfolio’s commodity allocation does not track the commodity market. For example, commodity-related equities will not necessarily reflect changes in the price of commodities and may actually have a higher correlation to movement in equities than the commodity market. Similarly, actively managed commodity futures accounts tend to reflect the manager’s skills rather than the commodity market.

Why Commodity Indices?

Investment vehicles that track commodity futures indices are not the same as actively managed futures accounts. Instead, commodity index returns provide passive exposure to a broad range of commodities. For example, the Dow Jones AIG Commodity Index tracks the futures price of 20 different commodities, including energy, livestock, grains, industrial metals, precious metals and “soft” commodities. Changes to the composition of the index are determined by preset rules rather than a manager’s discretion.

One advantage of commodity exposure that tracks a broad index is that commodities are not highly correlated with each other and index returns should be less volatile than the returns on an individual commodity. Another advantage is that commodity indexes themselves have existed for decades, providing ample historic data for asset allocation studies and research, of which there has been plenty.

Conclusion

Commodities are a distinct asset class with returns that are largely independent of stock and bond returns. Therefore, adding broad commodity exposure can help diversify a portfolio of stocks and bonds, helping reduce overall risk and enhance return potential. Achieving this diversification has been made easier with the development of investment products that passively track a broad range of commodities.

A note about risk: Commodities are volatile investments and should only form a small part of a diversified portfolio. Commodities may not be suitable for all investors. The use of derivative instruments may add additional risk. Consult your financial advisor to help you determine whether an investment in this Fund is right for you.