The key role of commodities

In this video update Danny Dhingra, Investment Manager, GAM Systematic, highlights what he believes are the key characteristics of commodities, including their potential diversification and inflation hedging benefits against a backdrop of uncertain markets. He also delves into the themes which drive commodity prices and explains how he thinks about and invests in them.

24 April 2024

What can commodities offer for investors?

Commodities are mainly credited with offering two interesting characteristics within the context of a wider investment portfolio. The first is diversification and the second is inflation hedging. First, portfolio diversification is quite an appealing trait when navigating uncertain financial markets. It can help to reduce overall volatility, thereby reducing portfolio risk. And that has historically contributed to smoother and more consistent return profiles through time. More specifically for commodities, the asset class has been empirically shown to display low to negative correlations to stocks and bonds over multiple economic cycles. It has particularly been of interest in the recent past, where at times we have seen the correlation between stocks and bonds tend towards one. And that has happened in pockets throughout history, so simply a combination of both those asset classes might not provide the most robust diversification potential that one might look for within a portfolio setting.

From an inflation protection point of view, market rhetoric over the past few years has really been driven by increasing and really stubbornly high inflation levels, potentially eating away at the value of portfolios. Thinking about this a little bit more broadly, commodities typically rise when inflation is accelerating. So they can really provide a valuable hedge against inflation. And we have seen that quite recently. In 2020, for example, post events like the pandemic, we have seen supply chain disruptions and Russia's invasion of Ukraine, just to name a couple. So commodities, true to their classical portfolio role as a diversifier and an inflation hedge, have provided good positive returns over that period.

What are the key themes driving commodity prices now and in the longer term?

We believe commodities as an asset class remain attractive from a return potential on both short-term and longer-term horizons. Over the short term, we believe that the development of certain topics could persist into the future. Those include geopolitical events, China and both on the short-term and longer-term horizons are weather-related issues. Just going into those in a little more detail, the regional conflicts in the Middle East and Eastern Europe have most definitely contributed to some meaningful changes in the prices of some important commodities. Take crude oil, natural gas and wheat, just to name a few. And then there is also the reopening of China that only fully took place at the beginning of 2023. As the world's second largest economy, it is really an important factor when considering the impact from a commodity demand point of view. Another point, which is now more persistently at the forefront of our minds, is weather-related issues and their potential impact on the supply of certain commodities. Cocoa has been an interesting example in recent times; we have seen the prices soaring because of poor growing conditions in Africa.

Looking at things a little more structurally and on a longer-term horizon, there are some key themes that we see developing within the commodity space. The first is the road to net zero. Companies and countries have now committed themselves to contributing to a net zero global economy. That not only requires stepping back in terms of energy emissions, but also making use of the increase in demand of energy transition metals; industrial metals such as lithium, nickel, aluminium, copper, again just to name a few. Another theme that is developing both in the short term and in the longer term is the increasing demand from global recovery as the world potentially returns to infrastructure spending and moving forward from a growth perspective. But just taking a step back and thinking about things as they are playing out now, a noteworthy point to consider is the diversification potential that commodities could deliver to a wider portfolio setting when equities have hit all-time highs and the future path of bonds and other fixed income instruments seems somewhat uncertain.

How do you think about and invest in commodities?

Our strategy aims to outperform commodity benchmarks through rules-based active management of enhanced, long only strategies, coupled with more opportunistic strategies that have low correlations to one another. The philosophy underpinning the selection and inclusion of these strategies is founded on two convictions. The first we believe is that there are typically persistent and recurring sources of returns in commodity markets that can be identified, isolated and systematically harvested. The second is that portfolio returns can overall be enhanced by combining investment strategies that have low correlations to one another. So it is really for that reason that our strategy is managed through a core/satellite approach that aims to complement the core enhanced long only book with alternative satellite strategies, designed to take advantage of opportunities in quite a dynamic way. Holistically the potential added value of the satellites, when well executed, lies within the high diversification potential that they could potentially offer to outright beta [the volatility or systematic risk of an asset compared to that of the overall market].