Commodities: Futures vs. Equities of Natural Resource Companies

In an earlier post, one of methods of investing in commodities is to buy stocks in companies that buy, sell or produce them.  A research paper written by RS Investments of San Francisco, California suggests that having an equity position in these companies is better for portfolio diversification, a better hedge against inflation and will have a higher return than commodities.

From 1970 to 1999, commodities as an investment was negatively correlated versus equities, provided protection against inflation and performed the same as equities.  This caused investments in commodities to increase from $15 to $354 billion from 2001 to 2010 as investors sought after improved risk-adjusted returns.  During this timeframe, commodities became more correlated with equities and had worse returns.  The article shows a chart with the correlation statistics for the Standard & Poor's Goldman Sachs Commodity Index (GSCI) and the MSCI World Index.   In the last five years, it has risen to 0.60 and is slightly higher, 0.64, during down markets.  For example, if the market has a 10% up move, then commodities will have a 6% up move.  In the last three major downturns in the stock market (1998, 2001 and 2008-9), commodities have negative returns too.  Contrast that with the bear markets from 1970 to 1990, commodities actually had positive returns.

From 2001 to 2010, equity indices in natural resources companies outperformed commodity indices.  The paper believes that this will continue because one of the return components of commodities has been affected negatively by the commodity futures curve.  The return is generated by the changes in the spot (current) price of the commodity, the roll yield and interest on collateral posted when buying futures contracts.  (These terms will be more fully defined in a later post.)

Both asset classes had high correlation with inflation.

A study on portfolio performance was done based on an 85%/15% equities to commodities/natural resource equities allocation.  Every portfolio with the 15% natural resource equities position had higher returns and lower volatility compared to the equity/commodities portfolio.

The author of the study is RS Investments and the paper can be found here or here.