Globally diversified portfolios are the best approach for dealing with the capital markets’ uncertainty. Unfortunately, all investors (including myself) can too easily fall into the traps of personal biases, which are well documented in the field of behavioral finance, pioneered by Daniel Kahneman, Amos Tversky and Richard Thaler. While these biases may be well-known and well-studied, phenomena such as herd behavior, loss aversion and extrapolation bias are still very much relevant today.
We find one bias of particular interest: extrapolation bias, or the sense that present market conditions will indefinitely continue. In today’s market, this seems most obvious in investors’ views of inflation. While we are not forecasting a major acceleration in inflation in the near future, we are acutely aware of the risks inherent to such an economic environment and the dire impact it would have on most investor portfolios.
Maintaining an exposure to inflation-sensitive assets on a strategic basis, which includes an allocation to the broad commodity complex, can be highly advantageous to investors. Commodities have shown a high degree of inflation sensitivity over time, along with an extremely favorable correlation profile to the other major asset classes.
Of course, one would be hard pressed to find an asset class more unloved than commodities in recent periods. Investors and advisors rail against this poor collection of real assets. Past performance? Terrible. Where’s inflation? Dead and never returning. No income, too complex, too expensive… The list goes on.
While these complaints certainly carry some merit—particularly cost for retail investors, most of the reluctance to include an allocation to commodities is attributable to a clear expectation that what has happened in the past (bad performance) will continue into the future (low to no inflation).
It’s worth pointing out that a traditional investor portfolio, such as the ubiquitous 60/40 allocation model, is already making an explicit bet on inflation. This portfolio is positioned for a deflationary environment because nominal bonds are explicitly short inflation, and strong evidence exists that equities also tend to perform poorly in periods of rising inflation. Clearly, all of price or wage inflation can’t be passed on to consumers, which can dampen earnings and serve as a headwind to equity performance. Adding a modest amount of commodities can reduce this deflation positioning and help make the overall portfolio more robust in different economic environments.
As modern portfolio theory reminds us, when an asset class offers extremely favorable correlation profiles, the return hurdle required to improve the portfolio’s overall risk-adjusted return characteristics is relatively low. In other words, lofty double-digit return expectations aren’t necessary to realize a total portfolio improvement by adding commodity exposure. Yet things have, in fact, been looking up for commodities. The recent increase in U.S. cash rates and the favorable term structure of commodity futures has vastly improved the “income” aspect of investing in this asset class. Today, commodities can provide positive carry from both underlying cash management and the “roll yield” created from many future contracts’ backwardation profile.
If investors have shunned commodity exposures in the past, now may be an excellent time to revisit this asset class. Central banks around the world appear prepared to kick-start another monetary policy easing cycle, unemployment rates remain at historically low levels, and wage pressures have started to firm. All these points suggest a particularly opportune time to consider adding this inflation-sensitive exposure and create a truly diversified portfolio.
Jim Smigiel is chief investment officer of non-traditional strategies at SEI, a global provider of investment processing, investment management, and investment operations solutions