The Rise and Fall of Commodity Indices

How Boom Turned to Bust

In the years leading up to the financial crisis, institutional investors significantly increased their allocations to commodity futures, from just $15 billion in 2003 to over $200 billion in 2008, according to a CFTC Staff Report. Most prominently, Harvard’s endowment took its target allocation to commodities from 6% in 2000 to 18% in 2008.
 
Commodity prices were in a sharp upswing at the time, driven by a surge in demand from China. And the hot topic of conversation among allocators was a major paper by two professors at Yale. Gary Gorton and Geert Rouwenhorst argued in a seminal 2006 paper that commodity futures had a higher risk-adjusted return than stocks and bonds (Figure 1) as well as a positive correlation to inflation (Figure 2) and thus could play an important diversifying role in investor portfolios.
 
Figure 1: Annualized Monthly Returns (1959–2004)

Source: Gorton and Rouwenhorst, 2006

Figure 2: Correlation of Assets with Inflation (1959–2004)

Source: Gorton and Rouwenhorst, 2006

With surging prices, major academic support, and Harvard’s endowment as the bell cow, the race to dump money into commodities was on.

But we now know this story did not play out as endowment managers had hoped or as Gorton and Rouwenhorst’s historical data might have implied. In fact, the increased enthusiasm for commodities nearly perfectly top-ticked the peak of a commodity super cycle. The financial crisis of 2008 would lead to a spectacular commodity crash and then a subsequent decade of muted returns, as the graph below shows.

Figure 3: GSCI vs. S&P 500 (1990–2020), Indexed to 100, Log Scale

Source: Bloomberg

Institutions ended up adding to their asset mix shortly before commodities entered one of the worst periods of underperformance in history. In Figure 4, we show that a hypothetical buy-and-hold commodity investor between 2006 and 2020 would have returned -7.5% compounded annually and endured a maximum drawdown of over 80%.

Figure 4: Performance Indicators for Oil and GSCI (2006–2020)

Source: Bloomberg, Verdad

This horrible performance materially impacts the long-term statistics for commodity indices. Below, we show that commodities have had essentially zero return from 1990 to 2020, while experiencing drawdowns of ~90%.

Figure 5: Comparative Performance of Commodities, Stocks, and Bonds (1990–2020)

Source: Bloomberg, Verdad

Over the last 30 years, a buy-and-hold strategy in commodities underperformed the S&P 500 by 10% and the classic 60/40 portfolio by 9%, while also enduring colossal drawdowns and significantly more volatility.

Yet a central argument of the commodity bulls has always been that commodities are uncorrelated to equities because of a strong positive relationship to inflation (see figure 2). The last 30 years have seen very high equity returns in the US with low and falling inflation. So perhaps looking at commodity returns with 2020 as the end point is as unfairly negative as looking at commodity returns with 2006 as the end point was unfairly positive.

Perhaps the better question is how to think about the drivers of commodity returns and the extent to which commodity returns are predictable and thus tradeable. Over the next few weeks, we will explore some of the major approaches to trading commodity indices and predicting returns, examining both factor-based approaches and macro approaches to trading commodities, with the goal of understanding what role commodities should play in a broader portfolio and when and why investors should invest in this asset class.

Acknowledgment: This piece was co-authored by three of our term-time interns, David Balass, James Patton, and James Lockowandt. David previously studied finance and economics and is now finishing a double-degree in common and civil law (JD/BCL) at McGill University. James Patton is a freshman at Harvard currently pursuing a concentration in neuroscience with a secondary in economics. James Lockowandt is a sophomore at Harvard on an exchange year at the University of Oxford where he studies mathematics and philosophy. Both Patton and Lockowandt are actively seeking internship opportunities in finance for next summer, while Balass is seeking full-time employment at a value-focused hedge fund upon graduating law school in December.