Commodities Vs. Inflation
Active and Passive Approaches
In “Bitcoin Vs. Inflation”, I looked at how a small investment in Bitcoin (“BTC”) would interact with an “inflation hedging portfolio” or “IHP” of Gold and TIPs.
Many investors view broader commodity investments as a way to potentially offset inflation risk. Here we will investigate how an allocation to commodities via a passive index or an active index might contribute to our IHP.
Bias Note: I have been allocating to active commodity strategies and have run dedicated portfolios of commodity trading programs for well over a decade — I tend to think an active approach to investing in or trading commodities is the way to go.
We will use the SG Commodity Trading Index for our active index, and will use the following Exchange Traded Products (“ETPs”) to access passive commodity indices: GSG, DJP, DBC. The SG Index is not investable, so we need to assume that real returns would be a bit lower. The common period of monthly returns for our sample of assets is 11/30/2006 through 5/28/2021.
The three commodity ETPs are highly correlated, so for simplicity of illustration we will use an equal weight portfolio of the three ETPs, rebalanced quarterly, as a proxy for passive commodity investment (“EW” or “Passive”). Now we can look at how active and passive commodities might help or hinder our base IHP of Gold and TIPs. Our two base portfolios are an aggregate of 3 commodity indices and an aggregate of active commodity traders.
SGCT vs. Passive
On a stand-alone basis, the active index is far more attractive than our EW portfolio of 3 passive indices — higher return, lower volatility and smaller drawdowns for the active Index. This doesn’t tell the whole story, however, as a less than attractive asset or investment might still add considerable value to a portfolio depending on its correlation with the other assets.
Adding to the IHP
Gold and the commodity index ETPs have much higher volatility than TIPs or the SG Index, so TIPs and SGCT will get higher weights than GLD and EW, much like we did in “BTC vs. Inflation”. We could get much fancier with our portfolio construction* but for this illustration we will use this very basic approach. Each portfolio is rebalanced to the target weights on a quarterly basis.
Now the fun part, let’s see how the three portfolios do!
The IHP (Gold and TIPs) does pretty well by itself. Adding the SGCT Index reduces return by a few basis points while lowering the volatility by more than 2% and lowering MaxDD and CDAR** substantially. This is a material reduction in risk, meaning we have a much smoother ‘ride’ through time while getting to roughly the same ending point in terms of portfolio value. IHP+SGCT has strong negative correlation to the USD [Beta of -0.53, t-stat > 8], as well, so the reduction in volatility does not come at a cost of reducing the potential to protect against inflation.
Adding the passive commodity portfolio to IHP reduces returns by about 1.5% while increasing MaxDD and CDAR a great deal — a much rougher ride with less return! I would hazard to guess that many investors would have trouble keeping an allocation to the passive commodity portfolio through time.
Conclusion
While passive investments in commodities may complement a portfolio sleeve designed to fight inflation, it may be too hard for many investors to actually stick with. Investors who want broad commodity exposure may want to consider actively managed strategies to include in their portfolio — the returns may or may not be better, but it seems that a key benefit of active managers (at least those tracked by the SGCT Index) is the much lower volatility and drawdowns. Behaviorally speaking, this should be much easier to stick with through time.
There are methods to make active allocations to index products which could make our passive portfolio more attractive, but we will leave that for another article.
Illustrations
Table 1: Return Data (Monthly Returns 11/30/2006–5/28/2021)
Figure 1: SG Commodity Trader Index vs. Passive Commodity Portfolio
Table 2: SGCT And EW Returns
Table 3: Portfolio Weights
Figure 2: Inflation portfolio performance
Table 4: Inflation Portfolio Performance Data
Figure 3: Scatterplot of IHP+SG portfolio vs. the USD
Notes
*I wrote a book on portfolio construction using Principal Component Analysis several years ago.
**CDAR = Conditional Drawdown at Risk
References & Resources
- Sample R Code: https://github.com/rufusrankin/CommoditiesVsInflation/blob/main/DemoCode
- Neville, Draaisma, Funnell, Harvey & Van Hemert, “The Best Strategies for Inflationary Times.” April 13, 2021 Version. From www.ssrn.com
Data
- GLD, TIP, GSG, DJP and DBC price data from Yahoo Finance
- USD Trade-Weighted Index (DTWEXBGS) from FRED
- SGCT Index Returns from Societe Generale: https://wholesale.banking.societegenerale.com/en/prime-services-indices/
Disclaimer
This article is for information purposes only and does not constitute investment advice. Any opinions are those of the author and do not represent those of Ampersand, Drexel University or any of their affiliates.
