Commodities Can Diversify Risk

The 2006 publication of Gary Gorton’s and K. Geert Rouwenhorst’s study “Facts and Fantasies about Commodity Futures” spurred an increase in the interest of using the asset class of commodities to enhance the performance of financial portfolios. In fact, commodity investments more than doubled from roughly $170 billion in July 2007 to $410 billion in February 2013.

The explanation for the rapid growth was that commodities could provide important diversification benefits—commodities have low correlations with both stocks and bonds. The low correlations are partly explained by the fact that commodities are correlated with different factors such as weather, geographical conditions and supply constraints.

In addition, commodities have been shown to hedge the risks of unexpected inflation, tending to perform best during periods of rising inflation, when nominal return bonds do poorly.

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