Commodities: A Portfolio Diversifier's Catalyst

It's been a year since the terrible epidemic caught the globe off guard, and investors, both
professional and retail, may learn vital lessons. Despite the fact that the pandemic is akin to
a black swan event, investors should always build their portfolios such that unanticipated
occurrences of apocalyptic proportions have the least influence on their investments.

The good news is that investors do not need to use complex or quantitative technologies to
safeguard their holdings. In reality, because most quantitative instruments are designed to
perform under 'normal' situations, they will fail under the anomalous conditions that would
be encountered during the pandemic.

In a perfect world, investors would enhance profits while lowering risk. What makes you
think this is possible? By diversifying your holdings. When it comes to tradable assets,
investors may invest in a variety of asset classes such as stocks, bonds, and gold. Diversifying
not just within a specific asset class but also across asset classes is a key aspect of investing.
It is not enough to have a diverse portfolio of equities, such as an index fund, but it is also
necessary to diversify across different assets, such as fixed income and commodities.
Commodities, according to commodity market research, provide strong diversity in a stock
and bond portfolio.

In a traditional portfolio optimization, high average returns and negative correlation to

stocks and bonds result in significant allocations to commodities.
Given the commodity futures index investment's historical risk-return profile – high average
returns and negative correlations to both stocks and bonds – it's maybe not unexpected that
a traditional portfolio optimization indicates a relatively high allocation to commodities
within a portfolio.

Commodities perform well in severe markets, above and beyond the means and variances
of traditional portfolio optimization.
The traditional portfolio optimization exercise demonstrates that commodities' historical
track record of high average returns, high Sharpe ratios, and low to negative correlations
with the major asset classes makes a compelling case for including commodities in a well-
balanced equities and bond portfolio. However, it is well understood that the historical
distribution of asset returns frequently differs significantly from the assumed normal
distribution in important ways, prompting an investor to consider factors other than
average returns, volatility, and correlations when evaluating asset performance. For
example, the historical distribution of returns for the "conventional" 60/40 equity-bond
portfolio reveals that "unlikely" occurrences occur more frequently than predicted by the
normal distribution. Furthermore, because extreme occurrences are more likely to produce
very low than extremely high returns, the distribution is said to be "skewed" to the left in
comparison to a normal distribution.
Commodities provide diversity in both equities and bond markets when it is most
required.
Diversification is more than a question of correlation in a world where extreme occurrences
are regular; it's also a question of whether an asset can dependably minimise portfolio
losses across a range of market situations. It's a question of whether the asset will provide
diversity when it's needed the most, in markets where the 60/40 equity-bond portfolio's
returns are at their lowest. Because the same factors that produce "spikes" in commodity
prices can also cause rapid falls in equities prices, a commodities allocation is a natural
buffer against poor performance of the 60/40 equity-bond portfolio due to real or predicted
disruptions in commodity supplies.

Futures contracts for commodities and the future of commodities investment

"Enhanced" index techniques have been a popular tool for investing in commodities as an
asset class in recent years. While the classic broad-based commodity index remains the
most popular benchmark for investing in commodities as an asset class, "enhanced" index
techniques have emerged in recent years as a viable option for commodity investments.
Enhanced Index Strategies, in general, are rules-based strategies that aim to beat
benchmark commodity indices by modifying index rules. Market concerns regarding
negative carry in commodities index returns owing to contango in futures curves that
accompanied the rise in physical prices to higher sustainable levels, primarily in the energy
markets, prompted the birth and fast dissemination of Enhanced Index Strategies in recent
years.

However, some of the new products that have arisen might be called a new generation of
commodities investment products, with some of them appearing to be superior to classic
benchmark Indices in terms of risk, return, and diversity. Simple changes in index rules were
the first moves toward market upgrades, with the goal of avoiding the Benchmark Indices'
"footprint." These changes included moving outside of the 5th to 9th business day of the
month frame established by the two main commodities indexes, the S&P GSCITM and the DJ
AIG, or continuously staying one or two contracts ahead of the Benchmark Indices' usually
front month futures contracts. However, as the market has evolved toward this sort of
strategy, any "alpha" generated from these types of technical methods has soon eroded,
with the index roll basically becoming a monthly event. It's unclear that a strategy aimed at
avoiding the index footprint will produce meaningful long-term outperformance.

Some of the other index upgrades that have been produced in the market, on the other
hand, deliver outperformance based on basic commodities market trends that are more
likely to continue over time. Some solutions, for example, alter index rules for commodities
with strong seasonal trends, such as natural gas, heating oil, and some agricultural and
livestock commodities. These seasonal strategies aim to outperform the Benchmark Indices
by rolling futures contracts for commodities with consistent seasonality in those times of
the year when the futures curves are more likely to be backwardated due to higher market
uncertainty, such as winter for Natural Gas or planting season for grains, as well as avoiding
rolling in those times of the year when the futures curves are more likely to be
backwardated due to historical contango in the market, such as summer for equities.

In a macro sense, these fundamentals-based enhancements provide a more customised way

for passive investors to provide risk capital to the marketplace, selling insurance to
producers during times when insurance is more expensive and avoiding times when
financial investors are effectively buying insurance. Dynamic rolls is another adaptation that
has been created for Crude Oil, which is a substantial component of commodities indexes
but does not display seasonality patterns. When the front end of the curve is in contango,
Dynamic Strategies roll crude oil futures contracts dynamically, shifting from the standard
front month roll to a roll further out the curve only when the front end of the curve is in
contango, minimising the negative carry that can be most pronounced. At other times, the
Dynamic Strategies are a carbon copy of the standard roll, profiting from the backwardation
in the curves and the positive returns that occur.

In a nutshell, outperformance from this technique occurs when the market has negative
carry, allowing financial investors to escape negative return headwinds during those
periods. Investors making strategic allocations to commodities as an asset class, as well as
those expressing tactical views in broad indexes or sub-indices on individual commodities,
have turned to Enhanced Beta strategies, which integrate the different changes outlined
above. Separately, the historical returns achieved by going long this sort of Enhanced Index
Strategy and short the equivalent Benchmark Index have attracted investors looking for
non-correlated sources of returns. We expect the creation of new financial solutions for
investing in commodities as an asset class to continue as investment flows to commodities
increase.