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Commodities and the Portfolio

Michael Humphreys CFA® CAIA®

Introduction

Commodities are publicly traded fungible raw materials that are inputs in production. There are three broad categories into which commodities are commonly divided: 

  1. Energy: crude oil, natural gas, gasoline
  2. Metals: gold, silver, copper, and platinum 
  3. Agricultural goods: corn, wheat, soybeans, and coffee

Metals can be subdivided into precious metals and stones (i.e., gold, silver, platinum, and diamonds) and base metals (i.e., copper, iron, and aluminum). 

The nominal value of the 2025 aggregate commodities market is estimated to be USD 142.85T with a projected compound annual growth rate (CAGR) of 2.64% through 2029 (Statista, n.d.). In finance, commodities are used for hedging, investment, and speculation via direct ownership, futures and forwards trading, open and closed end funds, ETFs, ETNs, structured notes, swaps, commodity pool operators (CPOs), commodity trading advisers (CTAs), and equities of commodity companies. 

For non-institutional investors, the primary benefit of commodities is their lower correlation with equities and fixed income products. The result of this correlation is an opportunity for investors to increase diversification, thereby decreasing a portfolio’s volatility and drawdown. As an individual asset class, commodities carry a higher sensitivity to market cycles, creating starkly contrasting periods of outperformance followed by underperformance. As such, Morningstar refers to commodities as supercycle investments that should be incorporated into a well-diversified portfolio with a holding period of at least 10 years due to the sector’s historical frequency of loss and maximum time to recovery (Arnott 2025). 

Valuation & Markets

The return to commodities is broken down into three factors: spot price, collateral yield, and roll yield. Studies show that historically, a commodities spot price accounts for 2% of its return, while collateral yield contributes 6%. The roll yield is less resolutely determinable, and will be positive or negative, depending on the commodity’s term structure of forward contracts. 

There are two basic states of forward contract term structures: contango and backwardation. In contango, a commodity’s spot price and near contracts are above its futures price. There are several theories as to why spot prices exceed futures prices, including the theory of storage (the idea of a negative risk premium on stored inventories) and the theory of hedging (the concept of commodity consumers, as hedgers, with a future commodity need are long forward contracts) (Arnott 2025). Regardless of the reason for contango, the result is that indexes and traders rolling contracts in a downward sloping term structure must sell a lower priced near contract and purchase a higher priced far-dated contract. The result of the roll is a loss, which equates to a negative return. 

In a backwardation market, the trader gains a positive roll yield because the spot price is greater than the current futures price. Thus, when rolling a contract, the trader incurs a gain as the near dated contract trades higher than the far dated contract. The theory behind market backwardation, according to Keynes, is that hedgers with inventory are short futures; thus, speculators receive a premium to make the market for hedgers. Thus, the futures price is below the spot price (Arnott 2025). 

The roll return premium is related to a commodity’s “cost of carry,” which is based on the arbitrage pricing theory that the full carry of a commodity is equal to its spot price plus the costs of financing, storing, transporting, and insuring the commodity. The relationship between a commodity’s spot price, futures price, and carrying costs comprise its convenience yield. A commodity’s convenience yield tells investors the value of holding a commodity versus holding futures contracts, meaning it is the implied return on holding inventories (Wikipedia 2023). 

In the Portfolio

Each instrument by which one can invest in commodities is subject to both positive and negative characteristics. As a non-institutional investor, the primary means of accessing commodity exposures are ETFs, ETNs, funds, structured notes, and equities of commodity producers. 


Empirical research shows the chief benefit of commodities in a portfolio is their low correlation with equities and fixed income. Moreover, commodities are normally positively skewed, which contrasts with the negative skew of equities, and thus, is widely received as a favorable counterbalance to equities. Individually, commodities are traditionally more volatile, but due to the lower correlation between equities and commodities, in aggregate the resulting portfolio has lower overall volatility and improved Sharpe ratios (a measurement to assess the risk-adjusted return). Versus equities, commodities have high kurtosis, indicating they are subject to more extreme movements in price. Precious metals have especially fat tails. 


Returning to correlations, the below table presents the results of a 40-year study of the correlation between commodities and various traditional investments. 


As one can see, commodities exhibit a history of low correlations with traditional assets. Additionally, the EAFE was found to be more highly correlated with commodities than US equities and US government securities. T-bonds, which are US government debt instruments with maturities of greater than one year but less than 10 years, were negatively correlated with all commodities. Precious metals are the only commodity negatively correlated with US equities. Inflation is positively correlated with all analyzed commodities but is mostly correlated with energy and precious metals. The high correlation with energy may, however, be heavily influenced by the macro environment of the 1970s. 

When the analytical period of 1970 to 2009 is divided into sub-periods of 1970 to 1989 and 1990 and 2009, the statistical performance of commodities is noticeably variable. Across both sub-periods, the most performant commodity sector was energy. Furthermore, and of most importance to investors, regardless of sub-period, commodities maintained low correlation with all traditional asset classes. 


More recent analysis by Morningstar again reinforced previous research on the diversification benefits of commodities but did find significantly poorer return performance than previous studies. Specifically, Morningstar states that following the China driven supercycle in commodities between 1991 and mid-2008, commodities have consistently lagged large-cap, small-cap, REITs, and the MSCI EAFE. Over the period of 1970 through 2024, the S&P GSCI produced annualized returns of 6.7% versus the S&P 500 which produced an annualized total return of 10.96% between January 1970 and December 2024 (PK 2012). 

Multiple studies have reinforced the benefits of commodities in investor’s portfolios, regardless of the equity style. The recommended allocation is greater than 5% to achieve diversification benefits. Macroeconomic conditions, namely monetary policy, coupled with the investors' risk profile, does influence final allocations. Regarding monetary policy, three conditions were found: 

  1. Expansive policy: higher allocations to commodities, proxied by the GSCI commodity index, resulted in lower returns, particularly in small-cap and momentum-focused portfolios 
  2. Restrictive policy: increased allocation to the GSCI resulted in improved performance, particularly in small-cap and large-cap portfolios
  3. Across both policy regimes: regardless of the monetary policy, expansive or restrictive, a greater allocation to the GSCI resulted in lower volatility

Conclusion

Before allocating to any asset class, investors should be cautious when extrapolating historical results into a dogmatic strategy. According to Erb and Harvey, there are four primary concerns with projecting past commodity performance into the future (Erb and Harvey (2006)): 

  1. The historical performance of commodities is predicated on a limited selection of commodities that have performed well
  2. The average equal weighted return across commodities is negative
  3. The return to commodities is principally the result of “diversification return,” which is the process of rebalancing among commodities with low correlations and high volatility 
  4. Commodities have a relatively low and inconsistent relationship with inflation, which provides little support for their role as an inflation hedge

Research does appear to reinforce the idea that commodities are useful tools for increased diversification, yet are subject to supercylces, are macroeconomic regime sensitive, and, over longer periods, tend to underperform equities on an absolute return basis. When held in a portfolio, empirical data suggests the allocation should be a part of the portfolio’s strategic asset allocation (i.e., a core holding) rather than part of the tactical asset allocation (i.e, as a trading strategy with greater focus on timing and macro conditions). Over a 10-year holding period, commodities do exhibit diversification persistence that results in higher Sharpe ratios and lower drawdowns. Therefore, the primary benefit of commodities appears to be risk mitigation. 


Sources:

Arnott, Amy C. 2025. “How to Use Commodities in Your Portfolio.” Morningstar, Inc. March 11, 2025. https://www.morningstar.com/portfolios/how-use-commodities-your-portfolio.

Erb, Claude B, and Campbell R Harvey. n.d. “The Tactical and Strategic Value of Commodity Futures.”

Jensen, Gerald R, and Jeffrey M Mercer. n.d. “Commodities as an Investment.” CFA Institute.

PK. 2012. “S&P 500 Return Calculator, with Dividend Reinvestment.” DQYDJ – Don’t Quit Your Day Job... (blog). May 7, 2012. https://dqydj.com/sp-500-return-calculator/.

Statista. n.d. “Commodities - Worldwide | Statista Market Forecast.” Statista. Accessed June 4, 2025. http://frontend.xmo.prod.aws.statista.com/outlook/fmo/commodities/worldwide.

Wikipedia. 2023. “Convenience Yield.” In Wikipedia. https://en.wikipedia.org/w/index.php?title=Convenience_yield&oldid=1179494120.


This material is intended for educational and informational purposes only. It is not intended to provide specific advice or recommendations for any individual. Additionally, you should consult with your Financial Advisor, Tax Advisor, or Attorney on your specific situation. The views expressed in the material are that of the author and do not necessarily reflect those of any market, regulatory body, State or Federal Agency, or Association. All efforts have been made to report or share true and accurate information. However, the information may become materially outdated or otherwise rendered incorrect due to subsequent new research or other changes, without notice. The author nor the firm are able to always verify the content from third-party sources. For additional information about the firm, please visit the MAS Website at https://www.mas.gov.sg/  and the SEC Website at www.adviserinfo.sec.gov. For a copy of the firm's ADV Part 2 Brochure, please contact us at info@avriowealth.com.