Pension funds are switching into commodities. This might not be just a jump onto a bandwagon. There’s a justification for it.
Our table shows this. It shows three optimal portfolios – ones that maximize returns for a given level of risk – drawn from five assets: UK equities, overseas equities, gilts, overseas bonds and commodities. These portfolios allocate between 5 and 20 per cent to commodities.
| Weightings in optimal portfolios | |||
| Lowest risk | Medium risk | Higher risk | |
| Commodities | 5.9 | 14.6 | 19.5 |
| UK equities | 0.0 | 33.4 | 55.3 |
| Overseas equities | 3.4 | 0.0 | 0.0 |
| UK gilts | 52.2 | 47.8 | 25.2 |
| Overseas bonds | 38.5 | 4.2 | 0.0 |
| Based on monthly returns since 1986 | |||
| Higher risk portfolio has two-thirds of the All-share’s volatility, medium risk one-half. | |||
The reason for this is simple. Although commodities are volatile – more so than equities in our data sample – they have low correlations with equities and bonds. They can therefore help reduce the volatility of a basket of shares and bonds. And because commodities have given higher returns than bonds, portfolios that seek more than the minimal level of risk will switch from bonds to commodities – although because equities have out-performed commodities, maximum-returning portfolios would contain only equities.
It seems, then, that pension funds are right.
Or are they? The weights in our table are based upon the monthly returns and correlations we’ve seen since January 1986. But if future returns and correlations differ from this sample, these weights will not be optimal. There are two particular ways in which this might happen, to the detriment of commodities.
| Monthly returns & correlations | |||||||
| Return | Volatility | Commodities | UK equities | O/s equities | UK gilts | O/s bonds | |
| Commodities | 0.91 | 5.92 | 1.00 | ||||
| UK equities | 1.02 | 4.51 | 0.10 | 1.00 | |||
| Overseas equities | 0.88 | 4.65 | 0.19 | 0.76 | 1.00 | ||
| UK gilts | 0.76 | 2.01 | -0.05 | 0.24 | 0.09 | 1.00 | |
| Overseas bonds | 0.67 | 2.39 | 0.28 | 0.19 | 0.36 | 0.43 | 1.00 |
Most obviously, commodity returns could be lower. In our sample, they (measured by Goldman Sachs index) have out-performed global bonds (measured by Citigroup’s index) by 0.24 percentage points a month. If we assume instead that their returns were to equal those on bonds – as Hotelling’s rule predicts – then their weighting would drop sharply, to less than one per cent in our medium-risk portfolio. Instead, equity weightings would be higher.
Secondly, the correlation between commodities and equities might be higher than it is in our sample (0.1 with UK equities and 0.19 with overseas ones). One obvious threat here would be a fall in global aggregate demand – for example caused by a drop in US consumer spending. In reducing demand for commodities and investors’ risk appetite, this would hurt both commodities and global equities.
These two problems suggest our table overweights commodities. But are they really so severe as to justify allocating nothing at all to commodities? It’s hard to believe that. So perhaps pension funds have got it right.
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