Are commodities still a justifiable diversifier?

By now, advisers can't help but wonder if they should get their clients out of commodities-linked funds and exchange-traded products. Certainly, the performance numbers have been nothing to cheer about. Year-to-date through June, open-end commodities funds tracked by Morningstar Inc. lost 10.8%, and exchange-traded products were off 12.6%. By comparison, U.S. stocks, as measured by the S&P 500 Total Return Index, gained 13.8%. The picture hasn't been any more rosy over the long term, either. Over the past five years, commodities funds and exchange-traded products lost 12.8% and 9.7% overall, respectively, compared with a 7% total return for the S&P 500. The main problem: Slow economic growth and lack of inflation have depressed commodities prices. The latest reading on the consumer price index — a 1.4% annual inflation rate for the 12-month period ended in May — was running below levels seen since the nadir of 2009, when the CPI came in at -0.4% for the year. AWAITING INFLATION “If there's no inflation, there's nothing to drive commodity prices,” said Brad Zigler, a consultant for institutional investors who specializes in hard assets. “Inflation has been wrung out of the commodities market,” he said. “In fact, expectations are playing in the opposite direction — toward deflation.” “We're not out of woods yet, with weakness in Europe and not a lot of demand coming out of the U.S.,” said Alex Bryan, a Morningstar analyst who covers commodities producers. Notably, after hitting an all-time high in 2011, the price of gold has fallen almost 40% to between $1,200 and $1,300 an ounce. Movement in the metal's price is widely seen as a harbinger of inflation. Of course, advisers use commodities-related products to diversify stock portfolios, not just to hedge inflation risk. Those who use an allocation to commodities products can point to the fact that, over the long run, commodities have not been highly correlated with stocks. But that relationship varies, and correlation has increased, thanks to the financial crisis. Stock-commodities correlation tends to rise during periods of economic weakness, according to a March research paper by Geetesh Bhardwaj, a director at SummerHaven Investment Management LLC, and Adam Dunsby, a partner. Using historical data back to 1960, the researchers observed higher correlations in the early 1980s and the late 2000s, both recessionary periods. Those results are “consistent with recession-increased risk aversion,” they wrote, as well as with the expected drop in demand for commodities as producers cut costs. Mr. Bhardwaj and Mr. Dunsby measured quarterly correlations ranging from -0.7 to 0.9. The financial crisis took stock-commodity correlations up to the top of that range, reaching 0.8 through the recession that began in the fourth quarter of 2007, according to the paper. “The last several years have been more of a risk-on, risk-off environment that's made diversification [with commodities] much tougher,” said James Weil, a partner at Financial Strategy Network LLC, whose usual allocation for clients is 3% to 5% in commodities-linked products. Treasury inflation-protected securities avoid the correlation problem and might be the better choice to help clients keep up with the cost of living, some observers contend. Inflation-adjusted bonds have a direct link to changes in the CPI, said Kevin Grogan, director of investment analysis at Buckingham Asset Management. Even so, Buckingham keeps about 5% of equity allocations in commodities products. BENEFITS OF EXPOSURE While commodities don't always provide a counterweight to equities and bonds in the short term, “you can't find a full year when all three have been down,” Mr. Grogan said. “That's the real benefit” from commodities exposure, in addition to some inflation protection, he said. Michelle Canavan, a Morningstar analyst who covers commodities funds, agrees. She noted that energy products, in particular, tend to have a higher correlation to inflation than agricultural commodities. One popular index with a heavy energy weighting is the S&P GSCI Commodity Index, which is about two-thirds energy-related, Ms. Canavan said. The widely used Dow Jones UBS Commodity Index is broader-based, with a 36.5% weighting to energy, and the rest to agricultural commodities and metals. “Any of these indexes have shown a correlation to inflation, looking back historically,” Ms. Canavan said. “You come out in the same place” with any of the indexes, Mr. Grogan said. Another option is buying the stocks of commodities producers. While products indexed to commodities markets have the advantage of providing pure exposure to spot commodities prices, stocks are generally cheaper, Mr. Bryan said. “There are more valuation metrics [with equities],” he said. Investors don't have to worry about contango, which can eat into returns as contracts are rolled forward, or the credit risk of an exchange-traded-note issuer. Of course, equities of commodities producers are likely to follow the ups and downs of the broad equity market, negating some of the diversification benefit from commodities themselves. “If you're just looking for diversification, a case can be made for a core allocation” to commodities, Mr. Bryan said.