New Report. ‘Commodities are Unique Among Asset Class, Provide Hedge Against Inflation’

(The Hindu BusinessLine) - Commodities are effective diversifiers and unique compared with other asset classes as they provide a hedge against inflation, says Credit Suisse Research Institute’s Global Investments Year Book 2023.

“Historically, commodities have had a low correlation with equities and a negative correlation with bonds, making them effective diversifiers… However, their inflation-hedging properties also mean that, in extended periods of disinflation, they tend to underperform,” the institute said.

Pointing to a 2022 study, it said commodity futures portfolios provide the instruments needed to hedge against different types of inflation.

“Energy futures perform well during energy-driven cost-push inflation; industrial metals during demand-pull inflation; and precious metals, especially gold, perform well when central bank credibility is questioned,” said the Switzerland-based institute, an arm of multinational financial services firm Credit Suisse, in a chapter exclusive dedicated to commodities and inflation.

Burdensome physical commodities

There is, however, a problem with the “attractive” asset class. “The investable market size is quite small. Thus, while individual investors or institutions may wish to consider increasing their exposure to commodity futures, large increases would be challenging if everyone sought to raise their allocations,” the research institute said.

The bank said investors tend to avoid physical commodities as dealing in them is burdensome.

“Investing directly in a commodity involves buying and storing it. Selling entails finding a buyer and handling delivery logistics and costs. This might be feasible in the case of precious or even industrial metals, but livestock, bushels of corn, frozen orange juice, and barrels of crude oil are more complicated,” it said.

Credit Suisse said storage and insurance costs can be large. There are also interest rate/carry considerations and this requires management time. Even if delegated to third parties, it adds a further layer of costs. Managing a multi-commodity portfolio is even more complex, it said.

‘Futures a great risk premium”

“Investing in commodity futures could generate a risk premium while investing in physical commodities has failed to do so after costs,” the bank said.

In the commodity futures market, investors need to be smarter than the market in forecasting spot prices to generate abnormal returns. But for those who do not have forecasting skills, investing in futures “still makes sense” if there is a risk premium.

The research institute made a study, tracking from 1877, on the monthly returns for 30 futures contracts which began on organised exchanges in the US and UK. The futures showed excess returns for an equally weighted portfolio of futures, turning “water into wine”.

“In every country, and for the world, the excess return on commodity futures dominates the excess return from both stocks and bonds. Non-American investors enjoyed an even more favourable relative return from futures than their American counterparts. These returns are, of course before costs,” Credit Suisse Research Institute said.

Optimal allocation

However, drawdowns for commodity futures are clearly not unusual.

“Drawdowns in risky assets are commonplace and commodity futures are no exception… It is harder for investors to stay the course in commodities than equities amid a comparable drawdown, given that commodities are less ‘conventional’. This can be a typical fate for a good diversifying asset,” the Swiss-based institute said.

Dwelling on commodities assets allocation, the research institute said it would depend on investors’ tolerance risk. But the optimal allocation for an investor, who is comfortable with a 60:40 risk in equity: bond portfolio, would be 18 per cent in commodities, 60 per cent in stocks, and 22 per cent in bonds.

By Subramani Ra Mancombu
February 26, 2023


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