An argument I typically hear for excluding commodities from a portfolio usually goes something like this:
“The Canadian market is heavily concentrated in commodity stocks, and therefore most investors already have plenty of exposure to commodities in their portfolio.”
Although this makes intuitive sense, let’s take a look at the facts and see if this argument holds any weight…
Since 1989, Canadian stocks have had 8 negative years of returns; in 4 of those years, commodity returns were positive. The return differences in those years have also been drastic – for example, in 2002, commodities returned 33% more than stocks! Furthermore, commodities have historically exhibited low correlation to Canadian stocks, indicating that they may be an effective diversifier of risk within a portfolio.
Sources: Dimensional Returns 2.0, Deutsche Bank
The table below contains the historical returns and standard deviations of the S&P/TSX Composite Index relative to the DB Commodity Index. Although the past performance of commodities does not look very compelling, recall that we should never view an asset class in isolation – it should always be viewed in the context of an overall portfolio.
When we compare two balanced portfolios (one with a 5% allocation to commodities and the other without) and rebalance them annually, we see some very interesting results. Although commodities had performed worse than stocks over this period (and had a higher standard deviation), the portfolio with a slight allocation to commodities had identical performance (8.7%). It also had a lower standard deviation (9.0%) relative to the all stock portfolio (9.6%). This is mainly a result of the rebalancing bonus – when two highly volatile and uncorrelated asset classes are combined together in a portfolio and rebalanced, the overall portfolio return can be higher than the weighted average returns of both securities on their own.
1 40% DEX Universe Bond Index, 60% S&P/TSX Composite Index (rebalanced annually)
2 40% DEX Universe Bond Index, 55% S&P/TSX Composite Index, 5% DB Commodity Index (rebalanced annually)
Although commodities should never be added to a portfolio with the intention of increasing expected returns (in fact, they should be expected to have a real return of zero), adding a small allocation to your Canadian portfolio does appear to offer diversification benefits in the form of lower volatility and insurance against inflation/supply shocks.