Will commodities protect you in bear markets?

(MoneyWatch) Despite the fact that the historical evidence demonstrates that adding a small amount of exposure to commodities to a portfolio has improved the efficiency of the portfolio, there are many who argue that you shouldn't consider including them. Among the arguments raised is that 2008 demonstrated that commodities don't hedge the risks of equities. In 2008, while the S&P 500 Index lost 37 percent, the S&P GSCI Index lost 46.5 percent. By looking at the historical evidence, we'll see that there are two major problems with this particular criticism.

First, 2008 wasn't unusual -- it wasn't the first time both stocks and commodities had fallen in the same year. In both 1981 and 2001, this had also occurred. As you should expect, each time the economy experienced a demand shock (in 1981 it was caused by the Federal Reserve sharply raising interest rates, in 2001 in was the events of Sept. 11, and in 2008 it was the financial crisis) both stocks and commodities fell in value. However, there were six other years from 1970-2011 when the S&P fell but the S&P GSCI rose. In other words, commodities hedge some (but not all) of the risks of stock investing.

For the three years when both the S&P 500 and the S&P GSCI fell, on average the S&P 500 lost 17.9 percent and the S&P GSCI lost 33.5 percent. Thus, it's true that replacing an allocation to the S&P 500 with an allocation to the S&P GSCI (of say 5 percent) would have produced worse results in those three years. However, there are two other issues we should consider. The first is that we should also look at what happens when we look at the other six years when the S&P 500 produced negative returns (1973, 1974, 1977, 1990, 2000 and 2002). For those six years, on average the S&P 500 lost 13.8 percent and the S&P GSCI gained 39.3 percent!

For all nine years when the S&P 500 produced negative returns, the average loss was 21.1 percent. During those nine years the S&P GSCI gained an average of 15.0 percent. Thus, overall we see clearly that in negative years for the S&P 500, adding an allocation to commodities improved the results of a portfolio just when those improvements were needed most. However, we haven't completed our analysis.

Harry Markowitz won a Nobel Prize for demonstrating that the only right way to consider an investment was to consider how its addition impacts the entire portfolio. For the period from 1970-2011, the annual correlation of the S&P 500 GSCI to one-year, five-year and 20-year Treasuries was -0.07, -0.14 and -0.14, respectively. We see evidence of this relationship when looking at returns to the S&P GSCI when bonds have negative returns. While one-year Treasuries didn't experience any years of losses, five-year Treasuries had three years, and long-term bonds had 10 years. In the three years when five-year Treasuries produced negative returns, the average return to the S&P GSCI was 19.9 percent. In the 10 years when 20-year Treasuries lost money, the S&P GSCI gained 31.9 percent. With this knowledge, we can create more efficient portfolios.

Because of the negative correlation of commodities and bonds, when we add commodities to a portfolio we can also add maturity risk (and earn the term premium). Let's see how this might work. Consider a typical 60 percent stock/40 percent bond investor. Let's assume this investor invests the stock portion in the S&P 500 Index and because they're worried about inflation risk they invest the bond portion in one-year Treasuries. Shown the diversification benefits of adding a small allocation of commodities (5 percent), taking the allocation from the stock portion, our investor decides to shift his bond allocation to five-year Treasuries. Let's see what happens to portfolio returns in the three years of negative stock returns and negative commodities returns.

We see that if we add commodities and also add duration risk that there was a small negative impact. Now let's look at what happened in the other six years when stocks produced negative returns.

For these six years when the S&P 500 produced negative returns, adding commodities and extending duration improved returns by 3.1 percent. For the nine years when the S&P 500 produced negative returns, the average loss for the portfolio without commodities was 6.1 percent. For the portfolio with commodities and longer duration, the average loss was 4.2 percent, an improvement of 1.9 percent, just when the improvement was most needed.

Because interest rates have experienced a long-term cyclical decline one should be careful about putting too much weight on the long-data. That's why we showed the evidence in the individual years of negative stock returns. With that said, the impact over the long term was positive as one-year Treasuries returned 6.4 percent and five-year Treasuries returned 8.0 percent. For the full period (1970-2011), Portfolio A returned 8.8 percent and Portfolio B returned 10.8 percent, with both portfolios rebalanced annually.

We see the same type results if we begin with five-year Treasuries as the fixed income allocation for the base case and switch to 20-year Treasuries when we add a 5 percent allocation to commodities. The table shows the results for the three years when both stocks and commodities had negative returns.

We see that if we add commodities and also add duration risk on average there was a negative impact of just 0.6 percent. Now let's look at the returns for the other six periods when the S&P 500 produced negative returns.

For these six years when the S&P 500 produced negative returns, adding commodities and extending duration improved returns by 2.4 percent. For the nine years when the S&P 500 produced negative returns, the average loss for the portfolio without commodities was 5.5 percent. For the portfolio with commodities and longer duration the average loss was 4.1 percent, an improvement of 1.4 percent, just when the improvement was most needed. And the impact over the long term was positive as well, as five-year Treasuries returned 8.0 percent and 20-year Treasuries returned 9.1 percent. For the full period, Portfolio A returned 9.5 percent and Portfolio B returned 10.2 percent.

Note that you don't have to move all the way from five years to 20 years to get some benefit. The important point is that one could take more duration risk if you add commodities exposure.

Returning to the original argument, stating one shouldn't use commodities to hedge equity risk because they don't hedge all of the risks of stocks is like saying you shouldn't buy fire insurance on your home because it doesn't protect you against floods. If you want flood insurance, you buy that as well. Similarly, when considering adding commodities to your portfolio, you should also consider adding duration risk.

Image courtesy of Flickr user USDAgov.