The Benefits of Commodities as a Diversifying Asset in Your Investment Portfolio

Commodities are fundamental to the real economy, yet they’ve often been overshadowed in the investment realm. Unlike stocks, they lack a consistent upward trend tied to economic activity, instead offering a range of unique price movements dictated by supply and demand dynamics. While individual commodities share some traits, they’re far from uniform, with low correlation among markets being a notable exception, though there are important nuances, especially within related commodities or substitutes.

Moreover, the logistical challenges and expenses of buying, selling, and storing physical commodities make them less accessible as investments, such as the complexities of dealing with live cattle or barrels of oil. Unlike anticipatory assets, commodities reflect present supply and demand realities, devoid of an income stream, which complicates their valuation compared to equities and fixed income assets. Their price history over nearly five decades shows modest growth with intermittent spikes, highlighting their non-linear trajectory.

Traditional Uses of Commodities — Inflation Protection and Diversification

A commonly cited rationale for including commodities with a bias towards long positions in a diversified portfolio is their historical track record as a dependable hedge against inflation. They are often praised for their effectiveness, especially in mitigating unexpected inflation, which often stems from shocks in commodity supply. This logic holds true as even with the current lower trajectory of real asset inflation, owing to shifts in demographics, technology, consumption, and productivity, starting from today’s low inflation levels implies that even a slight uptick in inflationary pressures could trigger significant asset repricing, underscoring the importance of commodities in an investor’s arsenal.

For many market participants, the extraordinary and coordinated fiscal stimulus following the COVID-19 pandemic has validated concerns about inflation. Since the last prolonged period of inflation occurred decades ago, most investors have no firsthand experience with it, making it challenging for them to gauge the likelihood of a sustained inflationary period or adjust their portfolio strategies accordingly. Investors often have short memories, making it harder for them to anticipate and prepare for such scenarios.

Diversification is often considered the only “free lunch” in investing. Combining low or negatively correlated asset classes in a portfolio has the potential to lower overall portfolio volatility without sacrificing returns (or to even improve risk-adjusted returns). Commodities tend to have low correlations to traditional asset classes, and they can potentially offer investors valuable diversification benefits

It’s crucial to adopt a long-term outlook when evaluating commodity performance. The above pic presents a comparison of the rolling three-year performance between a portfolio comprising 55% equity, 40% bonds, and 5% commodities, and a more conventional 60% equity, 40% bond portfolio. The performance of the commodity-inclusive portfolio has exhibited fluctuations over time. Following the 2008 Global Financial Crisis, portfolios with a minor exposure to commodities have generally lagged behind, albeit with slightly lower volatility on average.

However, from a risk-adjusted return standpoint, this reduced volatility hasn’t adequately compensated for the lower returns. Since the onset of 2019, including the peak of the COVID-19 pandemic, the relative underperformance of the commodity-inclusive portfolio has been marginal, prompting speculation about the potential strengthening of asset class correlations.

No one has a crystal ball, but long-term history suggests that there can still be some potential diversification benefits from adding commodities to a multi-asset portfolio. As far as inflation is concerned, to the extent that inflation surprises to the upside, a commodity allocation may still offer protection.

The integration of tokenized bonds with decentralized finance (DeFi) platforms could further revolutionize the financial ecosystem. Smart contracts could automate complex financial processes, enabling efficient lending, borrowing, and trading of tokenized bonds within decentralized networks.

Bru Finance

Bru Finance exemplify the real-world applications of tokenomics in the commodities market. Through tokenized bonds, they are pioneering the democratization of commodity investments, unlocking new avenues for investors and reshaping the way traditional assets are managed and traded.

The allure of commodities-backed bonds continues to grow across diverse categories of investors, from individuals to institutional players. The diversity of commodities available for backing, coupled with the promise of stable returns, makes these bonds a valuable addition to investment portfolios.

Decentralized finance takes the concept of commodity-backed bonds to the next level by tokenizing commodities and issuing bonds on blockchain networks. This approach introduces enhanced transparency, liquidity, and accessibility compared to traditional models.

In the DeFi space, platforms like Bru.Finance issues fractional commodity-backed bonds backed by real-world agricultural commodities at over 140% collateralization. Liquidity providers can subscribe to these 6-month bonds to earn yields.

What sets Brú Finance apart is its unwavering commitment to the interests of farmers and small businesses, promoting sustainability and financial inclusion. Fractional ownership features render their commodity-backed bonds accessible to retail liquidity providers, further promoting financial inclusion and asset liquidity.

Moreover, the advent of blockchain technology and digital assets has streamlined the issuance and trading of commodities-backed bonds. Blockchain’s transparent and efficient tracking of the underlying commodities reduces the risk of fraud and ensures greater accountability.

In today’s economic landscape, anything that enhances long-term expected returns with minimal additional risk is advantageous. While commodities recently endured a challenging bear market, they could become invaluable in the presence of inflation concerns arising from monetary and fiscal policy interventions. Although commodities appear to have stabilized for now, the potential for more pronounced deflationary outcomes or default crises typical of a new recession pose risks that might delay their upward trajectory. In such scenarios, long-term Treasury bonds would outshine commodities in the short term until reflationary forces regain momentum. However, after a prolonged disinflationary cycle leading to historically low Treasury yields, there’s a possibility that Treasuries (and entire fixed income allocations) may not offer the same level of diversification benefits as before. In such a scenario, exposure to commodities, whether through passive investment or an active alpha-seeking strategy, is likely to prove particularly advantageous.

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