Aurora Borealis
1 March 2014 CFA Institute Journal Review

Spot Commodities as Inflation Protection (Digest Summary)

  1. Thomas M. Arnold, CFA

The authors find that, in contrast to popular opinion, the ability of commodities and commodity aggregates to act as inflation hedges is weak. The aggregate for energy is the only commodity that provides an inflation hedge consistently over all high-inflationary periods throughout the authors’ 53-year study period.

What’s Inside?

The authors examine the return performance of 45 spot commodities and 13 commodity aggregates over a 53-year period (1960–2012) and find that commodities/commodity aggregates underperform such traditional investment choices as stocks and bonds. Furthermore, during the sample period, only a third of the 45 commodities outpaced inflation, only 7 commodities outperformed T-bills, and the only commodity aggregate generating a positive risk-adjusted return was energy.

During periods of high inflation, commodities do offer better returns, but their ability to hedge inflation is weak. Several commodities perform quite poorly during high-inflationary periods, and only energy outpaces inflation in every high-inflationary period in the full sample.

The authors find that, from a diversification perspective, most commodities are generally uncorrelated with stocks. After constructing an equally weighted portfolio of the 45 commodities in their study, the authors find that the portfolio outperformed inflation over the full sample period but generally did not keep up with inflation during high-inflationary periods. Consequently, the authors conclude that most individual commodities—and even a broad portfolio of commodities—cannot be reliably used to hedge inflation.

How Is This Research Useful to Practitioners?

Commodities are often cited as an asset class that offers inflation protection to investors. The authors conclude, in contrast, that commodities are generally not a good hedge against inflation. Even though the energy aggregate did perform well as an inflation hedge during the sample period, the authors note that it is not guaranteed to work as a hedge in the future. In summary, the authors’ findings suggest that investment professionals may need to look elsewhere when seeking assets that hedge inflation.

How Did the Authors Conduct This Research?

The authors collect monthly return data from the World Bank Global Economic Monitor database on 45 commodities and 13 commodity aggregates over a 53-year period (January 1960–December 2012). They use spot prices rather than futures prices—because most episodes of high inflation occurred prior to 1984, when most futures data were not available—to calculate returns, and returns are calculated without consideration for storage costs or transaction costs. The commodity returns are compared with inflation data and other return data representing stock and bond investments over the full sample period as well as subsample periods of high inflation (June 1967–December 1970, October 1972–March 1976, November 1977–October 1982, and March 1989–October 1990).

Holding period returns, real returns, and Sharpe ratios for the sample of commodities are compared with those of stock and bond benchmarks. In addition, the authors examine correlations between commodity and equity markets. Broad commodity exposure has historically experienced a long-term positive correlation with inflation and a low correlation with stock and bond markets. Investments in energy, metals, and the broad commodity market had positive real returns over the full sample period, but these returns varied substantially and were lower than those of stocks over the period. Investments in food and grain products have underperformed inflation over time. Diversifying across all commodity sectors, however, earns positive real returns with relatively low volatility.

Abstractor’s Viewpoint

I find the conclusions of the study—that commodities (including precious metals) do not always provide an adequate hedge against inflation—very interesting. The authors point out that if commodities are to be used as an inflation hedge, the timing is crucial, and I would emphasize that understanding the nature of the inflation is also crucial so that the appropriate commodity can be selected. I also concur with the authors that new financial instruments can potentially change the nature of using commodities as an inflation hedge in the future. Such instruments as exchange-traded funds and futures contracts might be beneficial for inflation hedging because spot commodities are not always a realistic option because of spoilage and storage issues.

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