A balanced 60/40 portfolio is known to be widely used by investors, combining the growth potential of stocks with the stability and income from bonds. Yet this investment strategy may not provide investors with the benefits that a more diversified portfolio could bring. No two assets behave identically under the same market conditions, so it can help to own a variety in a portfolio to meaningfully reduce exposure to any single asset or risk.
A commonly overlooked asset class that enhances portfolio diversification is commodities. But what benefits do they provide? The answer lies in their versatility. Commodities can act as a hedge against inflation, geopolitical risks, and also perform late in an economic cycle when other asset classes tend to come off. While not all commodities are created equal, each bearing their own unique characteristics, there are few assets as decorrelated from stocks and bonds as commodities, making them a good place to start if diversification is the objective.
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Source: WisdomTree, Bloomberg. Dates: from January 1990 to June 2023. European equity and Global HY start from January 1999, EU Corporate and EU Gov start from June 1998, European Carbon starts from November 2007 and California Carbon starts from January 2015. Historical performance is not an indication of future performance and any investments may go down in value. US equity: S&P 500 Total Return Index; Global e
To do so, investors might look to a broad commodity basket that provides access to 24 different commodities such as metals, energy and agriculture. Alternatively, they may lean towards gold depending on the role they want their allocation to play, or even highly decorrelated carbon allowances to provide the best sources of diversification.
Here are just a few examples of how and why broad commodities, gold and carbon could be good options for addressing this investment challenge.
As shown in table 1, commodities have a negative correlation with government bonds. Despite being a cyclical asset class, their correlations with equities are well below 0.5 and their correlations with corporate bonds are around 0.2.
So, what makes commodities behave differently to other asset classes, and why are they good candidates for diversification?
Firstly, commodities are a superior inflation hedge instrument, especially against unexpected inflation. Chart 1 shows the sensitivity of each asset class to (a) expected inflation and (b) unexpected inflation. Equities tend to decline with inflation while bonds provide some protection to expected inflation. The story is different for commodities, however, which stand out for being most sensitive to inflation and providing a hedge to the sources that are most difficult to predict.
Source: WisdomTree, Bloomberg, S&P. From January 1960 to June 2023 (Broad commodities and US equities), Jan 1973 to June 2023 (US Gov and US Corporate). Calculations are based on monthly returns in USD. Historical performance is not an indication of future performance and any investments may go down in value. Broad Commodities: Bloomberg Commodity Total Return; US equity: S&P 500 Total Return Index; US Gov: Bloomberg US Government Bond; US Corporate: Bloomberg U.S. Corporate Investment Grade.
Secondly, commodities often perform better than equities in late economic expansions and early recessions. Chart 2 shows that despite being a cyclical asset, commodities are not fully synched with equities. In fact, commodity prices tend to rise in early phases of a recession while equities are falling, and in later phases of an expansion, commodities tend to accelerate when equity gains begin to slow.
Source: WisdomTree, Bloomberg, National Bureau of Economic Research. January 1960 to June 2023. ‘Early’ is defined as the first half of an economic phase. ‘Late’ is defined as the second half of an economic phase. To account for different lengths of recessions and recoveries, monthly returns have been time weighted. Historical performance is not an indication of future performance and any investments may go down in value. US equity: S&P 500 Total Return Index; European equity: EURO STOXX 50 Net Return EUR; Global equity: MSCI World Net Total Return USD Index; US Corporate: Bloomberg U.S. Corporate Investment Grade; EU Corporate: Bloomberg Euro-Aggregate: Corporates; US Gov: Bloomberg US Government Bond; EU Gov: Bloomberg Euro Government; Global HY: Bloomberg Global High Yield; Broad Commodities: Bloomberg Commodity Total Return.
Finally, commodities have a different skew to equities. Large positive returns tend to be more common for commodities1 while substantial losses are more typical of equities2.
There are many ways to access the asset class through our diversified commodity ETFs. Our innovative solutions range from benchmark-tracking products to enhanced strategies with dynamic futures selection mechanisms. We also offer currency hedges and sector exclusions to match varying investment needs.
The WisdomTree Broad Commodities UCITS ETF provides access to a diverse range of 25 individual commodities by replicating the Bloomberg Commodity Total Return Index with the potential for outperformance by delivering its precious metals exposure through physical replication of gold and silver.
PCOM/COMX
The Fund seeks to track the performance, before fees and expenses, of the Bloomberg Commodity Total Return Index using an innovative replication method which includes direct exposure to spot prices for the precious metals portion of the index. Access as an accumulating share class.
As shown in table 1, gold has a low correlation with stocks and bonds. Its correlation with US bonds tends to be higher than its correlation with equities, however its correlation with European bonds — both government and corporate — remains very low.
This contrast with other asset classes is just the tip of the iceberg where gold is concerned. It behaves very differently to other cyclical commodities and is driven by factors3 that typically affect currencies, giving it its ‘pseudo currency’ reputation. For example, even though gold futures are part of a broad commodity allocation, they have a relatively low correlation with the rest of the complex and can be considered a separate exposure for diversification.
Gold also has strong defensive traits, witnessing price rises in market conditions where equities tend to struggle, such as financial crises, economic downturns and geopolitical shocks.
Gold’s strong performance during equity market crises is well documented, posting positive returns in 15 out of the 20 worst quarters of performance for the S&P 500. Of the remaining five quarters, gold has outperformed the S&P in four. Q3 1975 was the only quarter when gold fell harder than equities which came a year after it experienced abnormally large gains4.
Source: WisdomTree, Bloomberg. From December 1967 to 30 June 2023 using quarterly data. Historical performance is not an indication of future performance and any investments may go down in value. US equity: S&P 500 Total Return Index; Gold: LBMA Gold Price PM USD.
Finally, history goes to show that gold performs well in deep recessions and strong expansions. Given that inflation is often elevated in times of expansion, gold is not just a defensive asset. In fact, no other asset behaves this way, performing strongly in both economic downturns and upturns. This uniqueness in behaviour once again makes it a perfect candidate for diversification.
To illustrate this point, let’s look at the performance of gold alongside other assets at different points of the business cycle. It’s clear that gold performs the best in deep recessions and strongly outperforms defensive assets in times of economic expansion, explaining why its correlation to other assets is so low.
Source: WisdomTree, Bloomberg, Organisation for Economic Cooperation and Development. Recessions and expansions are based on amplitude of Composite Lead Indicators (CLIs), which are a proxy for economic output gaps. Period June 1989 to June 2023. Historical performance is not an indication of future performance and any investments may go down in value. US equity: S&P 500 Total Return Index; European equity: EURO STOXX 50 Net Return EUR; Global equity: MSCI World Net Total Return USD Index; US Gov: Bloomberg US Government Bond; EU Gov: Bloomberg Euro Government; US Corporate: Bloomberg U.S. Corporate Investment Grade; EU Corporate: Bloomberg Euro-Aggregate: Corporates; Gold: LBMA Gold Price PM USD; Silver: LBMA Silver Price PM USD.
Our suite of precious metals products provides investors with access to gold, silver, platinum and palladium, as well as precious metal baskets, available in physically backed and synthetic exposures. The WisdomTree Physical Gold ETCs provide exposure to gold bullion held in vaults in London or Zurich. The physical replication delivers exposure to the spot price of gold and all bars conform to the London Bullion Market Association (LBMA) Good Delivery standards. WisdomTree Physical Gold ETCs
WGLD/GLDW
WisdomTree Core Physical Gold is designed to offer security holders a simple, cost-efficient and secure way to access physical gold by providing a return equivalent to the movements in the physical gold spot price less the applicable management fee.
SGBS/SGBX
WisdomTree Physical Swiss Gold is designed to offer security holders a simple, cost-efficient and secure way to access physical gold by providing a return equivalent to the movements in the physical gold spot price less the applicable management fee.
GBSP
WisdomTree Physical Gold - GBP Daily Hedged is designed to offer security holders a simple, cost-efficient and secure way to access physical gold while mitigating the impact of currency risk. It provides exposure to the movement of the physical gold spot price less the applicable management fee, with a daily currency hedge against exchange rate movements (GBP Hedged).
GBSE
WisdomTree Physical Gold - EUR Daily Hedged is designed to offer security holders a simple, cost-efficient and secure way to access physical gold while mitigating the impact of currency risk. It provides exposure to the movement of the physical gold spot price less the applicable management fee, with a daily currency hedge against exchange rate movements (EUR Hedged).
Carbon pricing is an instrument that captures the external costs of greenhouse gas (GHG) emissions such as crop damage, healthcare costs linked to heat waves and droughts, and loss of property from flooding and sea level rise and ties them to their sources through a price. There is a growing consensus among governments and businesses on the fundamental role of carbon pricing in the transition to a decarbonised economy.
Investable carbon markets have a low correlation. The two largest carbon instruments in the world5: the European Union Allowances (EUAs) and California Carbon Allowances (CCAs), together account for over 90% of the value in global carbon markets in 20226. Table 1 shows that EUAs and CCAs have a low correlation with other asset classes and as highlighted in the graphic below, between themselves, indicating they can both be considered for portfolio diversification.
Source: WisdomTree, Bloomberg. Dates: Equity correlations from January 1999 to June 2023. Carbon correlations from January 2015 to June 2023. This chart shows the correlation between US and European equity markets compared to the correlation between US and European carbon markets: European Union Allowances (EUA) and California Carbon Allowances (CCA). Historical performance is not an indication of future performance and any investments may go down in value. US equity: S&P 500 Total Return Index; European equity: EURO STOXX 50 Net Return EUR; California Carbon: Solactive California Carbon Rolling Futures TR; European Carbon: Solactive Carbon Emission Allowances Rolling Futures TR.
Global warming is a source of catastrophe risk. In its latest report,7 the Intergovernmental Panel on Climate Change, the United Nations’ body for assessing the science related to climate change, concluded that human activities have unequivocally caused global warming — principally through GHG emissions. Their report concluded that every increment of global warming will “intensify multiple and concurrent hazards” and that climate change is a “threat to human well-being and planetary health”.
Carbon markets are designed to reduce GHG emissions. The price of carbon allowances will likely rise as policymakers step up efforts to meet climate goals by tightening the market. Prices may also rise if polluters fail to reduce their GHG emissions and need to buy more allowances than policymakers anticipated.
Investors in carbon markets are therefore hedging against catastrophe risk. They are future proofing their portfolio against risks that extend significantly beyond economic cycles and the traditional realms of finance. While carbon markets may have a short history relative to other asset classes which may limit quantitative analysis of the asset’s behaviour, we believe they may become one of the most important markets for diversification, with carbon pricing impacting almost every business decision.
Our suite of carbon products provides investors with exposure to the EU and California carbon allowance markets. WisdomTree Carbon ETPs The WisdomTree Carbon ETPs provide easy access to the prices of carbon allowances issued by the European Union Allowance (EUA) and California Carbon Allowance (CCA) programmes.
The WisdomTree Carbon ETPs provide easy access to the prices of carbon allowances issued by the European Union Allowance (EUA) and California Carbon Allowance (CCA) programmes.
WisdomTree Carbon provides exposure to the European Union carbon market. It is designed to reflect movement in the price of the ICE EUA (European Union Carbon Emission Allowances) front December futures contract (excluding fees).
WisdomTree California Carbon provides exposure to the California carbon market. It is designed to reflect movement in the price of the ICE California Carbon Allowance Current Vintage front December futures contract (excluding fees).
Sources
1 In technical terms, commodities have a positive skew, i.e. the distribution of commodity returns have a longer positive tail than a normal distribution.
2 In technical terms, equities have a negative skew, i.e. the distribution of equity returns have a longer negative tail than a normal distribution.
3 Key drivers of gold’s price include inflation, bond yields, exchange rates and market sentiment.
4 In 1974, gold prices rose by 72% before correcting downward by 24% in 1975.
5 WisdomTree: https://www.wisdomtree.com/gb/strategies/carbon
6 Source: Refinitiv Carbon Market Year in Review 2022, published February 2023.
7 AR6 Synthesis Report, March 2023.
