COMMODITIES IN A DIVERSIFIED PORTFOLIO: ROLE AND SIZING

Why invest in commodities?

Commodities—physical goods like gold, oil, natural gas, wheat, and copper—play a unique role in investment portfolios. Unlike equities or bonds, commodity returns are largely driven by macroeconomic trends, supply-and-demand dynamics, geopolitical developments, and weather patterns, rather than corporate profits or interest rates.

Investors seek out commodities for several key reasons:

• Diversification: Commodities typically exhibit low or negative correlation with traditional asset classes such as stocks and bonds. This means when equities decline, commodity prices may remain stable or even rise, helping to buffer overall portfolio losses.
• Inflation hedge: Physical commodities, particularly precious metals and energy resources, tend to appreciate during inflationary periods. This enables portfolios to maintain purchasing power as consumer prices rise.
• Exposure to global macro trends: Commodities can capture the benefits of global growth (e.g., copper in infrastructure expansion) or resource scarcity (e.g., agriculture and water-related investments).
• Tactical opportunities: Seasonality, weather events, and geopolitical disruptions often introduce price volatility in commodity markets, offering potential opportunities for tactical investors.

Commodities can be accessed through several instruments, including:

• Direct investment: Futures contracts and commodity spot markets (suitable for sophisticated investors familiar with derivatives).
• Exchange-Traded Funds (ETFs): These track individual commodities or commodity indexes, providing convenience and liquidity.
• Commodity-focused equities: Shares of mining, energy, or agricultural companies offer indirect exposure.
• Mutual funds and hedge funds: Professionally managed options that incorporate commodities as part of a broader investment mandate.

While commodities introduce unique benefits, they also carry specific risks. These include high volatility, lack of income generation (unlike dividends or interest), and exposure to unforeseen externalities. Therefore, including commodities in a portfolio should be done thoughtfully, with a clear understanding of their intended purpose and risk profile.

How commodities offer portfolio diversification

One of the key roles commodities play is enhancing portfolio diversification—a cornerstone principle of modern portfolio theory. Asset allocation across uncorrelated investments helps lower overall volatility and improves risk-adjusted returns over time.

Commodities stand out because their price movements often differ markedly from those of equities and bonds. While stock prices may tumble during economic downturns or periods of rising inflation, commodities such as gold or oil may perform positively, driven by different underlying factors.

Here’s how various categories of commodities contribute to broader portfolio stability:

• Precious metals (e.g., gold, silver): Typically seen as a safe haven during financial crises, political uncertainty, or inflationary spikes. Gold, in particular, remains a popular store of value.
• Energy (e.g., oil, natural gas): Influenced by geopolitical developments, OPEC decisions, and supply shocks. Price surges can coincide with events that negatively affect equities.
• Agricultural products (e.g., wheat, corn, soybeans): React to weather patterns, global food demand, and trade policies. Their performance is largely unrelated to traditional markets.
• Industrial metals (e.g., copper, aluminium): Correlate more closely with global economic activity and infrastructure investment cycles.

By including commodities with disparate drivers of return, investors can smooth out the cyclical performance of their portfolios. For example, when equity markets correct due to tightening monetary policy, inflation-sensitive commodities like energy or metals may rally, helping offset losses elsewhere.

According to historical data, the correlation between commodities and equities has fluctuated between negative and mildly positive, depending on the specific commodity and macroeconomic environment. For instance, from 2000 to 2020, gold maintained near-zero or negative correlation to the S&P 500 over various periods, enhancing its appeal as a diversifier.

Additionally, commodities may guard portfolios against specific risk exposures:

• Inflation risk: Commodity prices often rise with inflation, preserving real returns.
• Currency risk: Commodities are priced in US dollars globally. For non-USD investors, this may either hedge or exacerbate currency exposure.
• Interest rate risk: Unlike bonds, most commodities do not face adverse effects from rising rates. In fact, commodities often thrive during tightening cycles driven by inflation fears.

A diversified commodities allocation—spanning energy, metals, and agriculture—can help reduce portfolio drawdowns and improve overall resilience. However, correlations can shift during periods of extreme stress, so diversification benefits may vary over shorter timeframes.

Practical sizing of commodity allocations

Determining how much of a portfolio to allocate to commodities requires balancing diversification benefits against the inherent risks of this asset class. Unlike stocks or bonds that produce income or represent value-producing entities, many commodities do not yield cash flows, making sizing especially strategic.

There is no one-size-fits-all answer, and allocation depends on several investor-specific factors, including:

• Investment horizon: Longer-term investors might tolerate higher commodity allocations, leveraging their inflation-hedging properties over time.
• Risk tolerance: Those with a higher risk appetite may use commodities tactically and accept their volatility.
• Portfolios' existing asset mix: Heavily equity-weighted portfolios can benefit more from commodities than already well-diversified portfolios.
• Inflation outlook: In rising inflation environments, increasing exposure to commodities may act as a defensive manoeuvre.

As a general guideline, most institutional and retail portfolios allocate 5% to 15% of their holdings to commodities and real assets. Here's a breakdown of how commodity exposure might be implemented:

• 5% — Defensive allocation: Provides modest diversification and serves as a hedge against inflation. Typically includes gold or a broad commodity ETF.
• 10% — Balanced strategy: Incorporates multiple commodity types—precious metals, energy, agriculture—via ETFs or managed funds. Lower volatility instruments improve consistency.
• 15% or more — Tactical positioning: Allows active rotation among commodity sectors based on macroeconomic views. Suitable for more experienced investors willing to manage dynamic exposures.

Position sizing also has to consider:

• Leverage exposure in derivatives/futures: Futures contracts involve margin and can quickly exceed nominal portfolio percentages.
• Liquidity needs: Commodities can present timing challenges. Illiquidity in commodity-focused funds may complicate rebalancing.
• Tax treatment: Short-term commodity gains, especially from futures, may be taxed differently than long-held stocks or bonds.

One effective method for managing commodity allocation is using volatility-adjusted sizing—scaling exposures based on the volatility of the asset relative to the portfolio. This ensures position sizes are managed to equalise risk contribution rather than capital allocation alone.

Moreover, investors can use risk parity frameworks wherein commodities are allocated in proportion to their risk contribution, not just raw returns. These advanced techniques aim to build more balanced portfolios where no single asset class dominates portfolio risk.

Smart rebalancing is essential when commodities are included in multi-asset portfolios. Because of their inherent variability, commodity allocations should be reviewed at least quarterly, ensuring they remain within strategic or tactical bands aligned with investor goals.

As markets evolve, reassessing your commodity exposure regularly—not only for sizing but also for type (direct vs. derivative, broad vs. sector-specific)—is key to maintaining disciplined, diversified portfolios aligned with your expectations and risk capacity.