CAIA Level II: Advanced Core Topics in Alternative Investments, 2nd Edition

24.5 ASSET ALLOCATION

Commodities have been proven to enhance the risk-adjusted returns of diversified portfolios. Commodity returns have low correlations to stocks and bonds, but a higher correlation with inflation, particularly unexpected inflation and the rate of change in inflation. Research has shown that an allocation to commodities can improve the efficient frontier, or risk-adjusted return, of the portfolio. Additionally, research has shown that commodities have a low, sometimes even negative, correlation with one another, and so can offer uncorrelated investment opportunities across various commodity markets. In particular, the energy sector is frequently negatively correlated to the nonenergy sectors, because higher energy prices can weigh on economic growth and depress demand for other commodities. This correlation pattern can potentially help lower the risk of a diversified commodity portfolio (Till and Eagleeye 2005).

Commodity futures returns are positively correlated with inflation, and correlation has been shown to increase over longer time horizons. Because commodity futures returns are more volatile than inflation rates, long-term correlations better capture the inflation-hedging properties of commodity investments. While stocks and bonds are negatively correlated with inflation, the correlation of commodity futures with inflation is positive at all horizons and statistically significant at the longer horizons. Commodity futures' opposite exposure to (unexpected) ...