Investing in commodities: a viable addition to an investor´s portfolio?

Abstract

This thesis aims to provide a detailed analysis on whether or not adding commodities to a portfolio enhances its quality in terms of return and volatility. A special focus on commodities was chosen, due to their hedging capabilities (being that commodities are affected by such factors as weather, economic and political turbulence, supply limitations in production or unplanned increases in demand) and the fact that they are traditionally linked to very low correlations to equity and combinations of equity and bonds, as argued by Jensen and Mercer (2011) and Kayser, Paris and Ross (2011). Substantial empirical research in the field of commodity investment was analysed in order to be able to have a comprehensive overview on what other researchers found out about the diversification benefits of commodities in a portfolio. This was followed by an empirical analysis, consisting of calculating different portfolios by combining stock, bond and commodity indices over seventeen years, in order to draw a conclusion on whether or not superior risk-return profiles and better portfolio performances are noticeable in portfolios including commodities and how exactly these portfolios are composed. The empirical analysis is conducted with the means of Microsoft Excel and RStudio, for the time period from 02.01.2004 to 01.01.2021, by using weekly prices of four indices that represent three asset classes: the MSCI World Index - Total Return for stock price movements, the FTSE World Government Bond Index - Total Return for bond price movements, the S&P GSCI Commodity Index - Total Return and the Rogers International Commodity Index - Total Return (RICI) Index for commodity price movements. All four total return indices with global character were selected, all in the same currency, in order for them to be comparable, with the timeframe of seventeen years, allowing the commodity investment to be observed and analysed over a longer time period. These four indices are compared in terms of their return, their volatility and their correlation and covariance. Within this empirical analysis, the normality of the data used, i.e. in this case, the indices weekly rates of return, was tested with the Kolmogorov-Smirnov test, Shapiro-Wilk test, Q-Q Plot, the skewness and kurtosis analysis and the histogram. To test the research hypothesis of this thesis, three different portfolio optimization calculations were assumed. The first scenario does not contain commodities, i.e. the portfolio is composed exclusively of stocks and bonds. In the second scenario, one commodity index, the S&P GSCI Commodity - Total Return Index, is added to the portfolio, so that the portfolio consists of stocks, bonds and commodities, while in the third scenario, a different commodity index is added to the portfolio consisting of stocks and bonds, the Rogers International Commodity Index - Total Return (RICI) Index, so that the portfolio here also consists of stocks, bonds and commodities. Sharpe ratio and Value at Risk (VaR) are calculated and results of all scenarios analysed and compared in terms of all three scenarios. Additionally, a much shorter, five-year empirical analysis (01.01.2016 to 01.01.2021) was done as well, in order to challenge the findings of the seventeen-year empirical analysis. The hypothesis of the thesis was not confirmed by the empirical analysis of the paper. While analysing the indices in terms of their return, their volatility, commodities were proven to be a less attractive investment option when compared to stocks and bonds, since the annual rates of return of the two commodity indices were very low, with very high volatility. The correlation analysis concluded that a low correlation of commodity indices was found only in the case of the bond index, the FTSE World Government Bond Index - Total Return. High correlations with the stock index, the MSCI World Index - Total Return, were recorded with both commodity indices, failing to confirm the supposed main advantages of commodities (their very low correlation to equity and combinations of equity and bonds). The five-year empirical analysis (01.01.2016 to 01.01.2021) results in a similar conclusion. While analysing the risk-return profiles of all three scenarios, it is evident that the tangency portfolio (i.e. market portfolio) from the scenario without commodities had the most superior risk-return profile and the highest Sharpe ratio. Thus, even in the second scenario of the seventeen-year empirical analysis, the one with commodities, the maximum Sharpe ratio was found in the portfolio that did not include the investment in the commodity index at all. In the five-year empirical analysis, the portfolio with the highest Sharpe ratio in both Scenario 2 and Scenario 3 did not include commodity investments at all, once again supporting the evidence against the hypothesis of the paper. Even though some of the research also claims that adding commodities to a portfolio does enhance its performance, as already mentioned, based on this empirical analysis, it can not be argued that global investments perform better (have a better risk-to-return ratio) if they include commodities and that including this asset class in the portfolio is likely to enhance its performance, due to positive effects of diversification. In summary, the findings of this thesis are not in line with previous empirical research done in this field and as such offer a good addition to the existing empirical research and the overall argument when it comes to this topic, especially being that it observes portfolio performace over a longer time horizon of seventeen years – through both highs and lows of the commodity market. The time frame of this empirical analysis includes the financial crisis of 2008 and its impact on the markets and ends with the year 2020, the beginning of the COVID-19 pandemic. But how much of an impact exactly the pandemic and the post-pandemic years, complicated further by the changes forced upon the markets by the war in Ukraine, will have on the markets worldwide in the long-run would be a very interesting topic for additional research in this field of study in a few years’ time.