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Vanguard: Commodities Can Offer Outsize Inflation Hedge

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What You Need to Know

  • Inflation-sensitive assets such as commodities and TIPS can provide some protection to investors with a shorter time horizon.
  • TIPS can also provide some protection but offer a more limited hedge.
  • According to the Vanguard paper, commodities are about the present, while equity and fixed income are indicative of the future.

Incorporating commodities into portfolios can provide outsize protection against unexpected inflation as well as diversification benefits, new research from Vanguard suggests.

“Commodities tend to behave differently than traditional asset classes, especially when commodity price shocks are driven by unexpected changes in supply,” Vanguard noted in a  recent post based on the paper, “Commodity Investing and Its Role in a Portfolio.”

Over the past three decades, commodities’ inflation beta — or their sensitivity to inflation — has fluctuated between 6 and 9, the highest among all the asset classes analyzed in the study, according to Vanguard.

“This suggests that a 1% rise in unexpected inflation would produce a 6% to 9% rise in commodities,” the paper’s authors concluded. “In short, a small yet strategic commodity position can offer an outsized safeguard for an overall portfolio.”

While markets expect some inflation, unexpected inflation caused by supply disruptions — such as those caused by China’s extended, COVID-related factory shutdown and Russia’s attack on Ukraine — can prove particularly damaging for retirees and others with short time horizons, the authors noted.

Inflation-sensitive assets such as commodities and Treasury inflation-protected securities (TIPS) can provide some protection, according to the paper.

“Investors with a longer time horizon may fare well with equities as an inflation-fighting tool, but people who are concerned about purchasing power over the next five years may want to consider a strategic exposure to commodities futures,” one of the study’s authors, Fei Xu, Vanguard Quantitative Equity Group head of alternative and multi-asset investments, said in the post.

“Commodities prices in general trend upward as the cost of consumer-driven commodities like food and gas rise, which can lead to higher unexpected inflation,” he added.

Another study author, Anatoly Shtekhman, head of global advised portfolio construction, cautioned that “there is no silver bullet to fight inflation, but if short-term inflation hedging is the goal, historically, commodities have been an excellent choice.”

The study noted that while commodities offer protection against inflation, they have a lower risk premium than equities, which tend to outpace inflation longer term. “Replacing equities with commodities in a strategic portfolio may result in underperformance compared to a market-capitalized portfolio,” the paper said.

TIPS are a popular inflation hedge but have relatively low inflation beta and offer a more limited hedge, Vanguard suggests. A commodities allocation can provide a significant inflation hedge to the portfolio beyond the commodities themselves, according to the paper.

A small commodities position can provide an effective inflation hedge, with the optimal percentage depending on the inflation environment, economic conditions and investor risk tolerance, Vanguard said.

Because macro factors and current supply-demand dynamics directly affect them, “commodities are all about the here and now, while equity and fixed income are indicative of the future. The benefits of having diversification and positive real return expectations can make commodity investing an attractive component of strategic asset allocation,” the study said.

“The historically strong relationship between commodities and inflation makes this asset class even more compelling for goals-based investing, specifically for unexpected inflation hedging.”

(Image: Adobe Stock)


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