The current bout of inflation we're facing has already defied expectations many times. What was first labeled a "transitory" rate of price increases has proved instead to be persistent—seemingly immune to the Fed's aggressive rate hikes to date.
Few investments have provided much help to investors trying to keep up with this inflation cycle. Major stock and bond indexes have fallen significantly this year. Cash offers little hope of keeping up with rising prices. Even usual inflation hedges like real estate investment trusts (REITs) and Treasury Inflation-Protected Securities (TIPS) have struggled to hold their ground. Commodities have been one of the market's few bright spots.
While commodities have historically performed well during most periods of high inflation, it's important to remember they are a unique asset class. Commodities have historically behaved differently from stocks and bonds, including rising and falling at different times (put another way, they tend to have low correlations with traditional investments).
Performance of stocks and bonds may depend on considerations like the issuer's business prospects, the current phase of the business cycle, and the current interest-rate environment. Performance of commodities depends more on the supply and demand for the commodity itself—which can be influenced by the economy, but also by weather patterns, production decisions by OPEC, and more.
Compared with traditional asset classes, commodities' performance has been highly volatile, and has often lagged over longer periods. (Read more about the current outlook for commodity prices.) So investors should think carefully about their objectives and risk tolerance before establishing an allocation to the asset class.
Types of commodity investments
Commodities generally fall into 3 categories—energy, metals, and soft commodities. Energy includes oil, natural gas, and more. Metals include precious metals like gold, but also industrial metals like aluminum and copper. And soft commodities include agricultural products like grains, livestock, and coffee.
A challenge posed by the asset class is that it is neither feasible nor economical to directly invest in commodities (which would entail directly buying barrels of oil and bushels of wheat). Instead, investors generally have 2 options: investing in commodity futures contracts, or investing in shares of commodity-producing companies (like oil producers and gold miners).
Neither of these types of instruments provides perfect price tracking of the day-to-day spot price movements of the underlying commodities. But each can offer some exposure. Performance of futures can reflect both current price movements and expectations for future price movements of the commodities (a futures contract is a contract to buy or sell something at a set price on a set future date). Performance of commodity-related stocks can reflect changes in the commodity's price but also other factors, like macroeconomic conditions and company-specific considerations.
While some investors may prefer to choose and manage a portfolio of individual commodity investments themselves, many may be better served by the diversification and liquidity of mutual funds and ETFs.
What role in a portfolio?
The appropriate way to think about commodities is as a specific type of insurance, says Larry Rakers, portfolio manager and group leader with Fidelity's Strategic Advisers. "The reason you would consider commodities is that they have often risen in value with rising inflation expectations," he says.
But because their performance has historically lagged stocks and bonds over the long term, commodities may not be an all-weather investment. Naveen Malwal, institutional portfolio manager with Fidelity's Strategic Advisers, notes that for this reason his team doesn't always maintain positions in commodities.
"We believe that a diversified mix of US and international stocks, bonds, and short-term investments can lead to long-term growth in a risk-managed way," he says. "We believe commodities can be helpful at times. But we tend to think of that as a position we take on occasion, as opposed to a foundational position that we always have in a portfolio."
While many investors expect inflation to decline from here, it could always defy expectations yet again by rising or persisting at higher-than-expected levels. In that scenario, an allocation to commodities could provide a benefit. Rakers adds that the asset class can also provide a degree of insurance against geopolitical risk, such as possible escalation of the war in Ukraine putting further pressure on grain and energy prices.
Investors who are concerned about inflation surprises and want to establish an allocation to commodities should think carefully about what type of vehicle to choose. While there are many funds and ETFs that specialize in tracking only one commodity, a fund that offers broad diversification may come with less volatility.
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Article initially appeared on fidelity.com
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