Commodities: A Catalyst in Portfolio Diversification

It is a year since the devastating pandemic stuck the world unawares, and there are valuable lessons to investors both professional and retail investors alike. Although there is no denial of the fact that the pandemic is almost like a black swan event, investors should always construct their portfolios such that these unforeseen events of cataclysmic proportions have minimal impact on their portfolios.

The good news is to make the portfolios secure, investors need not resort to complicated and quantitative tools. In fact, most quantitative tools will fail during the abnormal conditions that are confronted during the pandemic, because most quantitative tools are designed to work under ‘normal’ conditions.

Ideally, investors need to increase the returns and reduce the risk at the same time. How this is possible? By investing in multiple assets. If you look at tradable assets, people generally have the option of investing in different types of assets like equity, bond and gold. One of the fundamental tenets of investing is diversifying not only in a given asset class but also across the asset classes. For instance, it is just not sufficient holding a diversified portfolio of stocks a la index fund but also diversify across different assets like fixed income and commodities. Table 1 gives the risk return dynamics of these three popular assets for the last 10 years in India. Equity is further subdivided into large cap, mid cap and foreign equity.

Research on commodity markets reveal that commodities offer good diversification in a portfolio of stocks and bonds. We explored the diversification possibilities of all the commodities that are available to an investor in India through commodity futures in the bullion, base metal and energy category in a diversified portfolio of stocks and bonds. What is the level of diversification offered by various commodities? What types of commodities offered the best risk adjusted returns when used along with equity and debt? What type of equity offered the best risk adjusted returns when used along with commodities and debt? We studied the rewards and risks of different asset classes and the portfolios with various combinations of these asset classes. Table 2 provides the summary of portfolios with a reward to risk ratio higher than 1.5(higher than bond, equity and gold held individually) using last 10 years of data.

The best risk return combinations were obtained by compulsorily including five assets given above. One of the combinations of the five assets, as per our study, fetched the lowest risk of 3.86% with a return of 8.89% and another combination fetched the best reward to risk ratio of 2.47. Commodities add value not only with Indian equity, but also with foreign equity. NASDAQ 100 ETF offered the best risk adjusted returns (among the three types of equity included in the study) when combined with bond, gold, and base metal. All commodities offer some level of diversification but commodities like gold, aluminium, and zinc offered the best diversification for stock and bond portfolios in the last 10 years. It is also observed that for majority of the portfolios with the combinations of these five assets in the range mentioned above, the risk level was even lower than that of a bond portfolio that consists of only government bonds.

If we take a recent period of Jan 2020 to Feb 2021, it was observed that an investor who just held equity will do poorly compared with holding 80% in Equity and the remaining in a bond portfolio. The reward to risk ratio, fancifully termed as Sharpe ratio, is 0.87 for the former portfolio and 0.95 for the Equity plus bond portfolio. Further, the Nifty and bond portfolio augmented with gold (80:10:10) had an even better reward to risk ratio of 0.98. The commodities edge is found to improvise the reward to risk ratios even for fixed income investors. The reward to risk ratio for a bond only portfolio is 2.12 while a portfolio with 80% allocation to bonds and the remaining to gold is having a superior reward to risk ratio of 2.39. A portfolio of Nasdaq 100 ETF, bond and gold (80:10:10) with a reward to risk ratio of 1.87 trumped the Nifty, bond and gold portfolio.

For a long-term investor, commodities like aluminium and zinc can further augment reward to risk ratio. Therefore, a moderate allocation to these commodities along with gold will help both bond and equity investors alike. Currently, commodity futures are a very effective way of taking direct exposure to commodities. Financial institutions like asset management companies, stock exchanges and commodity exchanges may take advantage of these dynamics and can offer products with better risk adjusted returns.

Sony Thomas and SSS Kumar are Associate Professor and Professor respectively at the Indian Institute of Management, Kozhikode (IIMK)