Optimal Commodities

To counter the effects of shocks due to the COVID-19 global pandemic, governments are implementing a variety of support and stimulus measures of a scale not seen since WWII. In addition, many governments around the world seem poised to embrace the economic prescriptions of Modern Monetary Theory, leading to massive fiscal expansion and the potential for a large inflationary shock.

Commodities like oil, copper, corn and sugar are consumed in the manufacturing and shipping of virtually every product. Rising commodity prices erode the profit margins of manufacturers and distributors of goods, or are passed along to consumers in the form of rising prices. For this reason, commodities can act as a direct hedge for many types of inflation.

If commodities are an integral weapon in investors’ arsenals to defend against inflation, this motivates a search for an optimal investable commodity portfolio. In this brief we analyze the most popular commodity indices and compare them against a passive commodity strategy that simply seeks to maximize the diversity of commodity exposures. We also introduce long-only factor tilts which may enhance the long-term performance of the commodity basket.

Key takeaways:

  • High levels of market and sector concentration in popular commodity indices means they are both ineffective hedges and inefficient portfolios
  • Optimal commodity portfolios that seek to maximize diversity hedge against more diverse types of inflation
  • Optimal commodity portfolios also benefit from a large potential rebalancing premium, upwards of 5% annualized
  • Factor tilts toward trend, carry, seasonality, skewness and value may preserve hedging properties while substantially improving portfolio outcomes