Should Commodities Have A Role In Your Portfolio?
It may depend on your inflation expectations.
Key takeaways
With inflation continuing to prove persistent, investors may be reevaluating whether their portfolios include sufficient inflation protection.
Commodities can potentially offer a degree of protection against worse-than-expected inflation.
That said, because of their history of low long-term returns and high volatility, investors who decide to invest may want to consider keeping any allocations to commodities relatively small and well diversified.
The current bout of inflation we're facing has already defied expectations many times. What was first labeled a "transitory" rate of price increases seems instead to be proving persistent.
The rate of inflation has come down markedly in the past year as the Fed's interest-rate hikes have taken effect. For example, the annual rate of change in the Consumer Price Index has declined from a high of 9.1% in June 2022 to 5.0% in March. But that rate is still elevated compared with historical levels and compared with the 2% level that's generally considered healthy for the economy.
While it's always possible that inflation could decline steadily and smoothly back to that 2% sweet spot, there's also a real chance that it could remain at an elevated level for some time. Given that risk, some investors may be taking a second look at investments traditionally considered "inflation hedges," like commodities.
While commodities have historically performed well during most periods of high inflation, it's important to remember they are a unique asset class. Commodities have historically behaved differently from stocks and bonds, including rising and falling at different times (put another way, they tend to have low correlations with traditional investments). Performance of stocks and bonds may depend on considerations like the issuer's business prospects, the current phase of the business cycle, and the current interest-rate environment. Performance of commodities depends more on the supply and demand for the commodity itself—which can be influenced by the economy, but also by weather patterns, production decisions by OPEC, and more.
Compared with traditional asset classes, commodities' performance has been highly volatile, and has often lagged over longer periods. So investors should think carefully about their objectives and risk tolerance before establishing an allocation to the asset class.
Types of commodity investments
Commodities generally fall into 3 categories—energy, metals, and soft commodities. Energy includes oil, natural gas, and more. Metals include precious metals like gold, but also industrial metals like aluminum and copper. And soft commodities include agricultural products like grains, livestock, and coffee.
A challenge posed by the asset class is that it is neither feasible nor economical to directly invest in commodities (which would entail directly buying barrels of oil and bushels of wheat). Instead, investors generally have 2 options: investing in commodity futures contracts, or investing in shares of commodity-producing companies (like oil producers and gold miners).
Neither of these types of instruments provides perfect price tracking of the day-to-day spot price movements of the underlying commodities. But each can offer some exposure. Performance of futures can reflect both current price movements and expectations for future price movements of the commodities (a futures contract is a contract to buy or sell something at a set price on a set future date). Performance of commodity-related stocks can reflect changes in the commodity's price but also other factors, like macroeconomic conditions and company-specific considerations. (Learn more about the pros and cons of commodity investing.)
While some investors may prefer to choose and manage a portfolio of individual commodity investments themselves, many may be better served by the diversification and liquidity of mutual funds and ETFs (scroll down for the steps to research commodity funds and ETFs on Fidelity.com).
What role in a portfolio?
The appropriate way to think about commodities is as a specific type of insurance, says Larry Rakers, portfolio manager and group leader with Fidelity's Strategic Advisers. "The reason you would consider commodities is that they have often risen in value with rising inflation expectations," he says.
But because their performance has historically lagged stocks and bonds over the long term, commodities may not be an all-weather investment. Naveen Malwal, institutional portfolio manager with Fidelity's Strategic Advisers, notes that for this reason his team doesn't always maintain positions in commodities.
"We believe that a diversified mix of US and international stocks, bonds, and short-term investments can lead to long-term growth in a risk-managed way," he says. "We believe commodities can be helpful at times. But we tend to think of that as a position we take on occasion, as opposed to a foundational position that we always have in a portfolio."
While many investors expect inflation to decline from here, it could always defy expectations yet again by rising or persisting at higher-than-expected levels. In that scenario, an allocation to commodities could provide a benefit. Rakers adds that the asset class can also provide a degree of insurance against geopolitical risk, such as a war or military conflict which could pressure grain and energy prices.
Investors who are concerned about inflation surprises and want to establish an allocation to commodities should think carefully about what type of vehicle to choose. While there are many funds and ETFs that specialize in tracking only one commodity, a fund that offers broad diversification may come with less volatility.
"It is incredibly hard to predict the direction of individual commodities," Malwal says. So if you've decided to add commodities to your portfolio, consider keeping the allocation relatively small, and well diversified.