Commodity futures as inflation hedge

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With inflation persistently high, many investors want a reliable hedge which will minimize the risk that inflation erodes the real value of their wealth. The latest version of Credit Suisse Global Investment Return Yearbook 2023 reports that commodity futures provide an effective hedge against inflation because they had a positive correlation with inflation whereas bonds, equities and real estate tend to be negatively correlated with inflation (see the chart from the report below). Historical data show that inflation has negatively impacted both bonds and equities, and real estate somewhere between them. Contrary to a conventional wisdom that equities are a hedge against inflation because they are a quasi-real asset, equities were a poor hedge against inflation. Although equities have been hurt less than bonds under a high inflation regime, they are not a true hedge against inflation. However, commodity futures – pooled together as an asset class – do provide a reliable hedge against inflation and serve a good diversifier in a multi-asset portfolio.

Why commodity futures and not investing in individual commodities on the spot market? The simple answer is returns. According to the data from Yearbook 2023, spot commodities yield very low long-term returns since 1900, with an average annualized loss of 0.5% in real terms. In fact, 72% of the commodities that the authors of Yearbook analysed failed to beat inflation. However, an equally-weighted portfolio of the same spot commodities offered a much higher annualized return of 2% because a portfolio of commodities has much lower volatility due to very low cross-correlations. Note that most of academic research use equally-weighted portfolios because they avoid excessive tilts towards certain segments of commodities at times. Returns aside, purchasing physical commodities is cumbersome. Investing directly in a commodity involves buying and storing it. In addition, investors have to deal with the logistical and insurance costs (think oil, cotton, corn or livestock in the millions of dollars). For ordinary investors, commodity futures are a far simpler way of investing in commodities because they are more convenient with lower transaction costs. Commodity futures perform even better. According to the theory of normal backwardation, there should be a risk premium that accrues mostly to buyers despite occasional contangos. Between 1877 and 2022, the portfolio of commodity futures outperformed the portfolio of spot commodities by almost 2.5 per cent per annum.

Furthermore, commodity futures portfolios offer the instruments needed to hedge against different types of inflation. Energy futures perform well during energy-driven cost-push inflation like 2021 and 2022; industrial metals during demand-pull inflation; and precious metals, especially gold, perform well when central bank credibility is in question. Of course, there are downsides in investing in commodities. For example, they have a tendency to underperform during the periods of disinflation, and they are greatly exposed to recession risk. In terms of liquidity, commodity futures markets are relatively small compared to other asset classes. So, if investors crowd into commodity futures, there would be a risk of bubble and a subsequent burst. Even though a surge of launching commodity ETFs has increased the size of commodity futures exponentially, futures markets still remain miniscule.

The seminal paper by Gorton and Rouwenhorst published in 2006 found that commodity futures act as an almost perfect diversifier, reducing the risk of a portfolio of bonds and equities without undermining returns. They documented that investing in an equally weighted index of commodity futures generated an annualized risk premium of 4.2% from 1959 to 2004. Soon after the publication of their paper, commodity futures suffered a deep and long drawdown. Two most popular commodity futures indices, S&P GSCI and Bloomberg Commodity Index, have not yet recovered their 2004 level yet. In a subsequent paper, Bhardwaj, Gorton and Rouwenhorst (2016) attribute this drawdown to the global financial crisis in 2008. Correlations within many asset classes tend to rise sharply during periods of financial turmoil and a disinflationary period post-GFC was a challenging condition for commodity futures. Going forward, what risk premium can we expect from a long-run investment in a portfolio of commodity futures? From the historical perspective, a well-diversified portfolio of collateralized commodity futures is expected to deliver around 3% risk premium according to Yearbook 2023.

Inflation appears to have peaked in 2022 but it may take longer before inflation drops to the central bank’s target range, in particular, from the current high level. If investors are concerned that inflation will not go without a fight, the case of commodity futures in a multi-asset portfolio looks very compelling. With inflation at four-decade highs, it is a great time to consider investing in commodities. While commodities offer several benefits – diversification, reduced portfolio volatility and inflation hedging – investing in them may be challenging. But these derivatives are volatile and complex, and futures trading can expose regular investors to unfamiliar risks. That makes commodity ETFs the safest instrument for most investors. There are many commodity ETFs available in the market, and they are constructed based on different benchmarks and instruments. So, before selecting commodity ETFS, investors should carefully consider their investment goals of adding commodity ETFs into their multi-asset portfolio.

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