One size doesn’t fit all
By Emily Holbrook
Commodities can be used in an institutional portfolio to meet different objectives like diversification, inflation protection, or even low-growth-protection. While supply, demand, and geopolitical issues all affect commodity prices, they can still offer return enhancement and are therefore common in institutional investing portfolios.
But along with the benefits of commodities in an institutional investing strategy, are the disadvantages. Broadly speaking, commodities have been more volatile and had historical returns that barely kept up with inflation. Commodity returns have a very low correlation to returns of U.S. stocks and bonds and so commodities can be well-suited as a diversifier for a U.S. investor. However, one size doesn’t fit all.
Harsh Parikh
“A Canadian investor with more home country bias already has large energy equity exposure when compared with an investor investing largely in world equities — 15.6% vs. 3.8% as of January 31, 2022, according to MSCI,” said Harsh Parikh, Principal of PGIM’s Institutional Advisory & Solutions group. “So, for a Canadian investor, an off-the-shelf commodities benchmark may not be as diversifying if it were to have higher energy sector allocation.”
Investment in commodities growing
Institutional investors are increasing their exposure to commodities either directly or indirectly. Parikh notes that investors in natural resources or farmland are exposed to many different commodities such as lithium or avocados, which may not even be part of an off-the-shelf commodities benchmark. For example, with changing consumption patterns (e.g., increased use of electric vehicles) some commodities may have an increased demand (e.g., lithium used in batteries) and some less (e.g., palladium used in catalytic converters).
“Also, with concerns about sustainability, institutional investors may shift their focus to commodities that currently are taken for granted, such as water or commodities that thus far were in ample supply, such as solar grade polysilicon,” Parikh said.
Commodities as an inflation hedging tool
Commodities more broadly are an effective hedging tool against inflation but not all commodities are a good inflation hedge. For instance, Parkih explained coffee has no inflation exposure whereas wheat has high inflation exposure.
Gold is another example of a commodity that works well as a hedge against inflation. Parikh noted that gold is both a safe haven in stagnant markets of low growth and low inflation, and also protects against inflation in stagflation, or low growth and high inflation. The investor’s investment horizon also matters to determine whether a commodity is an inflation hedge or not.
“While gold may have low correlation to inflation at a monthly horizon, it becomes more correlated to inflation at longer horizons such as 3-year and 5-year,” he said. “Gold-related assets like gold ETFs, futures, equities, and royalty and streaming agreements have a place in long-horizon institutional portfolios separate from broad commodities.”
Benchmarking challenges
Generally, institutional investors use off-the-shelf commodity benchmarks to guide their real asset investing. However, these benchmarks are typically production-weighted and are not constructed with the CIO’s investment objectives in mind. The macroeconomic sensitivities of these benchmarks vary depending on the commodities’ production weights. In addition, what may be an inflation hedge for a U.S. investor may not be an inflation hedge from a Canadian investor’s vantage point. After accounting for currency returns, inflation exposures may be different for a commodity.
Parikh advises CIOs to construct their own benchmark that targets a specific investment objective over their investment horizon. A customized benchmark more suited to a Canadian institutional investor’s investment objectives should be constructed in this case.
“For example, a CIO can construct a well-diversified commodities benchmark that targets high inflation exposure over a 3-year horizon,” he said. “Such a benchmark has lower allocation to the energy sector than a diversified off-the-shelf commodities benchmark.”
Emily Holbrook serves as owner and head content creator at Red Label Writing LLC, a content studio that collaborates primarily with the insurance and financial services sectors.
