This is the third article of Financial Advisor IQ’s four-part special report on inflation.
Traditionally, commodities like precious metals — typically gold and silver — have been the go-to options for protecting investor portfolios in inflationary periods. But today, the options available are increasingly broad. Investors can buy futures in anything from coffee to crypto, land and natural resources, that have also been havens during periods of inflationary pressure.
Over the course of 2021, U.S. inflation has jumped to 6.2%, the highest rate since November of 1990, according to the U.S. Bureau of Labor Statistics, meaning commodity hedging could make its way into advisor-client discussions in the coming months.
“Different commodities tend to shine in different macroenvironments, and each one can be subject to its own specific market risk,” said Tyson Romanick, CFA and assistant vice president and portfolio manager at Baker Boyer Bank.
Romanick says commodity hedging is all about timing. Holding investments for too long could massively impact returns, as illustrated by fluctuations in lumber, compared to base metals over the last year.
“Holding a basket of commodities through an exchange-traded fund or managed futures fund is a good way to gain exposure to commodities,” said Romanick. “These funds have professional managers overseeing the portfolio and these types of investment vehicles offer daily liquidity. You do have to be mindful that managed futures funds can be a little complicated to explain to clients.”
Commodities’ Traditional Position
Traditional commodity investing tends to involve skewing exposure towards commodities that are expected to perform best in an inflationary environment, which is driven by supply and demand.
In fact, Will Rhind, founder and chief executive officer of GraniteShares, said this is the main reason for choosing one commodity over another. “Other than macro considerations such as wanting a low correlation to the stock market or trying to protect against inflation, the main reason for choosing one commodity over another would be fundamental factors like supply and demand.
“Many commodities are currently rising in price because demand is outstripping supply. This is particularly pronounced at the moment in energy markets such as European natural gas where prices are trading at the equivalent of approximately $250 a barrel in oil,” he added.
But Stephen Ewen, partner at Mercer, emphasizes that this is a short-term solution rather than a long-term, sustainable investment strategy.
“We don’t generally see commodities as protection against cash drag given that the long-term expected rate of return for commodities, broadly, is similar to cash,” he said.
“In the short run, commodities tend to be economically sensitive, and in that manner, correlated to equities, with the exception of gold. If your concern is one of inflationary pressures, commodities do tend to be one of the best near-term protections against inflationary pressures, as we’ve seen year-to-date,” he added.
The Advice Position
Financial advisors are currently poised for the Federal Reserve to begin winding down its stimulus program, which could cause ripples for equity and bond investors, while fielding client concerns about inflationary cash drag.
Traditional commodity hedging can offer some protection against the impacts, according to GraniteShares’ Rhind, who suggested that given that inflation is the highest it’s been since the 1970s, when it spiked to above 11%, cash in portfolios is losing value on a “real basis.”
Rhind said, “Gold has historically tended to move inversely to the U.S. dollar and has the potential to hold its value over time, so holding gold in the portfolio instead of cash is a way for investors to hedge against a decline in the dollar or a rise in inflation.”
He explains that as inflationary periods settle in, traditionally, the prices of natural resources and other commodities tend to rise.
“Commodities as a whole have historically demonstrated a positive correlation to inflation and can be used in the portfolio to hedge against this risk,” he said. “This is typically because inflation measures, or benchmarks, tend to include things like energy and food prices, which, along with other commodities, are included in broad commodity ETFs.”
But there are a variety of ways to provide clients with a commodity hedge for their portfolios.
Mercer’s Ewen explained, “Commodities could be incorporated into one’s investments in a variety of manners to include trend following, active management — fundamental and quantitative — relative value, equity and debt of commodity producers, etc.”
This all has to start with a discussion about the clients’ objectives and how best commodities can be used to help meet these, he explained. Ewan added, “Any investment advice should begin with a discussion around the objectives and role that one is expecting the investment to offer. At present, with the markets weighing the intermediate-to-long-term impacts of the inflationary environment, commodities represent a natural topic for consideration.”