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Fixed Income and Commodities Thumbnail

Fixed Income and Commodities

A few days ago, we fielded a question that we thought others might have and wanted to share the answer and some data that may be helpful in light of recent market activity.

 

When we allocate a client’s portfolio, there are both strategic as well as tactical considerations.   Before explaining some of those considerations, let’s first review the four main asset classes that one might see in a portfolio.

  • Cash 
  • Equities
  • Fixed Income
  • Commodities

 

Most are familiar with the first three categories.  Commodities, however, is not as common. To some extent, this is due to the fact that it is a little harder to invest in commodities.  As a result, it is also very uncommon to see a commodity option inside a 401(k) or similar company sponsored retirement plan – which is where most people are introduced to investment options. Some examples of commodities are:

  • Oil, Natural Gas, etc.
  • Precious Metals – Gold, Silver, Palladium, etc.
  • Wheat, Soybeans, Corn, or other agricultural products
  • Beef, Pork, or other livestock

 

Many have heard the term “diversification,” and are familiar with the concept. The reason one diversifies a portfolio is because the outcome of any one investment is uncertain. Therefore, by investing in multiple positions, we attempt to limit the damage one losing position might have on our overall portfolio.  Diversification can’t solve all problems, though, and in a declining market it may not be enough to head off a loss.

 

To take the concept one step further, we would typically like to see a portfolio comprised of positions that have the potential to act in dissimilar manners.  For example, if we hold position A and position B but they behave differently, position A might be up while position B might be down.   This is why the industry traditionally advocates for a portfolio to be strategically allocated between the two main asset classes of equities and fixed income; simply put, they behave differently.  So, if the equities markets are down, the fixed income portion of the portfolio might be up.

 

However, tactically speaking, in the environment where we currently find ourselves, we need to adjust. To this end, we have increased our exposure to commodities and decreased our exposure to fixed income.

 

In general, commodities are not something we keep in a portfolio at all times.  However, this is an important asset class to consider having in a portfolio mixture as it is not highly correlated with equities – meaning that if the equities markets correct, the commodities market could continue to rally.  Traditionally, fixed income plays this role.  However, in the low-yield environment in which we find ourselves, fixed income is likely going to struggle. 

 

What should we do, tactically? Let’s review two charts to answer that question.

 

Chart #1 (below) is the US Aggregate Bond ETF.  The chart illustrates October of last year thru year-to-date.  This position is a reasonable proxy for the United States Fixed Income market. A quick glance at the chart reveals the point we have been making. The question is: In the environment in which we find ourselves, and are likely to remain in for the foreseeable future, do we really want a lot of this in our portfolio? We believe the answer is a resounding no! Should fixed income remain in a portfolio? Of course, for the right investor (depending on the risk tolerance). But perhaps we should hold a little less than we typically might for the time being.

 

Chart #1

 Chart: iShares Core US Aggregate Bond ETF (AGG) – 1 Day Line Chart Source: Optuma Data from TD Ameritrade

 

Chart #2 (below) shows the chart for the iShares GSCI Commodity-Indexed ETF for the approximately same time frame as the example of the bond market (above). While GSG is indeed a reasonable proxy for the commodities market, this ETF is not in our portfolios. This ETF is not a traditional ETF organized under the 1940 Investment Act and is, therefore, taxed differently. We are mentioning this ETF because it can serve as a reasonable proxy for the entire commodities market.   It is not a recommendation.

 

Having given that disclosure, a simple glance at the chart reveals why we might want to increase our exposure to this asset class, though through a different ETF.  (In our case, most of our models now hold three commodity ETFs but ones that are organized under the 1940 Investment Act.)

 

Chart #2

 Chart: iShares S&P GSCI Commodity-Indexed Trust (GSG) – 1 Day Line Chart Source: Optuma Data from TD Ameritrade 

In the end, we need to be diversified. However, we do not want to be diversified by holding an asset class that is trending negative just because it is traditionally held. Having a long-term strategy is important. But we also must maintain tactical awareness and adjust as the situation warrants.

 

Our responsibility is to do what is in the best interest of our clients. At times, that will mean reallocating our portfolios away from investments that are trending down and moving towards investments that are trending up. Keeping that in mind, we want to make sure you come away with a couple of key points:

  • Fixed income investments may continue to struggle (trend down).
  • Commodities investments may continue to rally (trend up).
  • Reducing our fixed income exposure may help reduce volatility and provide a bump in returns in the short-term.

 

As always, please do not hesitate to reach out if you should have any questions.  We appreciate the opportunity to serve you and your family.