While investing in commodities ranks among the oldest of financial endeavors, commodities today are underrepresented in most trust portfolios because of the widespread perception that they represent a volatile and risky asset class. Also, investing in commodities themselves has produced over the long term a return that is roughly equal to the rate of inflation.

But a more in-depth analysis shows that historical returns for commodities-futures indexes demonstrate a low correlation with both equities and bonds. Thus, including a commodity-futures index in a portfolio of stocks and bonds could reduce risk in most portfolios, making them a suitable asset class for consideration under the Uniform Prudent Investor Act (it may vary from state to state). Moreover, the historical returns investing in a broad-based commodity-futures index have exceeded those of both stocks and bonds over the very long term.

A compelling case can be made that the strong returns of commodities in recent years were not merely a short-term trading opportunity but rather the product of a significant shift in the global economy. The tighter integration of emerging economies into the global trading system is driving a pronounced industrialization and urbanization throughout the developing nations of the world. The strength of these trends means that commodities prices may continue to rise even if inflation remains muted in developed markets.

There are equally persuasive reasons for believing that the low correlation between financial assets and hard assets will persist, thus preserving the role of commodities as a valuable portfolio diversifier. Throughout modern market history, hard assets such as commodities and financial assets have responded in fundamentally different ways to such macroeconomic phenomena as the business cycle, inflation and event risk — and there are sound reasons to expect these different responses can persist.


The tremendous volatility in commodity prices experienced during the 1970s and the 1980s still shapes investor perceptions. This is understandable, given the magnitude of the swings: Oil prices soared from $1 a barrel in 1973 to $39 in 1981 before plummeting back below $11 in 1986. Gold ran from its fixed price of $35 per ounce in the 1960s up to $850 in 1980, then fell back to $290 by 1985. Since then, however, the volatility of commodity prices has been much more subdued — even after accounting for the recent run-up sparked by strong demand for commodities from the developing world. In all, and perhaps surprisingly, the rate of return on an equally weighted index of commodity-futures contracts1 has exceeded that of both stocks and bonds during the past 46 years. (See “Commodities-Futures Index Has Performed,” p. 32.)

Perhaps more unexpected, the volatility of that equally weighted basket of commodities futures index2 has been lower than that of stocks during those same 46 years. (See “An Efficient Investment,” p 32.) This gives the equally weighted commodity-futures index a higher return per unit of risk (the Sharpe ratio). The higher the ratio, the greater is the efficiency of the investment.

But an investment in a commodity-futures index offers more than just potentially attractive returns and relatively low volatility; it can also provide important diversification benefits when combined with other asset classes, such as equities, bonds, hedge funds, private equity and real estate. This is because the returns on commodities investments exhibited low correlations with those of U.S. stocks, a negative correlation with bonds, and low or negative correlation with many alternative investments. (See “An Efficient Investment,” p. 32.)

There are fundamental reasons why the returns on commodities and financial assets have low correlations with one another. First, commodity prices tend to rise in response to increases in the rate of inflation (and vice-versa), whereas the values of stocks and bonds tend to fall with increases in the inflation rate. That is, signs of higher inflation usually boost commodity prices, whereas higher inflation tends to diminish the value of financial assets, particularly bonds.

Second, commodities prices tend to rise in times of economic shocks or crises, while those of stocks and bonds tend to fall. The reason is that surprises in the global economic system almost always reduce the supply of some commodities to the marketplace: Weather, political instability or civil strife all impair commodity production, driving up their prices.3 These events raise production costs and undermine investor confidence, all of which diminish the value of financial assets, namely stocks and bonds.

The different responses of commodities, stocks and bonds to inflation and to economic shocks underscore why commodity returns tend to have little correlation to financial asset returns. Most importantly, these characteristics mean that commodities provide diversification when it is needed most: during times of extreme negative equity returns. Note the returns on commodities during periods when the S&P 500 fell more than 5 percent during any calendar year: Between January 1960 and December 2005, there were nine times when the S&P 500 fell more than 5 percent during a year, and in all cases but one, the returns on an equally weighted commodity-futures index were positive. (See Benefits of Diversification,” p. 33.)


Given these attractions, a portfolio manager must determine which vehicle provides the best opportunity for investing in commodities. He can simply purchase the underlying commodity to gain exposure. But actual ownership of a commodity can be problematic, because ideally, the owner would need a warehouse to store some barrels of crude oil in one corner, bushels of wheat in another corner, and a pen of live cattle in the middle of the space. Obviously, this method is not practical for most investors.

Another way to get exposure to commodities is by investing in the equities of firms that derive a significant part of their revenues from the purchase and sale of physical commodities. Of course, this is not the same thing as getting direct exposure to commodity prices (and changes in those prices). Owning stock in a commodity exposes the investor to the financial structure of the company issuing the stock, other businesses in which that company might be involved, changes in that company's accounting practices and the company's management talents. Perhaps most importantly, the investor is exposed to the possibility that the management might hedge the risk associated with the purchase and sale of commodities to smooth their annual earnings. Look at the relationship between the Goldman Sachs Energy Index and the S&P Energy index as well as the Goldman Sachs Agricultural Index and the S&P Agricultural Products Index. In both cases the regression equations demonstrate poor fit with data, thus indicating little interdependence between returns on natural resource companies and the commodity that drive significant portions of their revenue base. (See “The Disconnect,” p. 33.)

From the viewpoint of liquidity, breadth of participation, and ease of trading, the most favorable means of investing in commodities comes either through the commodities-futures indexes4 or from an active manager such as a commodity-trading advisor (CTA). Some active managers might indeed create value. CTAs may invest in both exchange traded futures contracts and forward contracts. Most CTAs, however, are likely to be holding positions in non-commodity futures, such as currency and other financial futures, so they have exposure to a lot more than just commodity prices. Also, most CTAs are considered trend followers and may take both long and short positions in commodities futures contacts. For these reasons, a CTA does not give consistent positive exposure to the asset class of commodities.

A fully collateralized commodity index can represent returns an investor could earn from continuously holding a passive long-only position in a basket of commodities futures contract. Composition is key to choosing the appropriate commodities index: A given commodities index may be widely used and traded, for example, but if it is heavily weighted towards a particular commodity, it's an imperfect index for broad commodity exposure. For example, a heavy energy weighting may increase an index's exposure to political events — both negative and positive — in the Middle East, Russia and the other major oil-producing regions, as well as to emerging alternative energy sources. Also, an index with low exposure to metals may mean that such an index may not fully participate in one of the more promising commodities investment groups.

Portfolio managers may wish to look for an index that is broadly diversified and has a balanced weighting in energy, industrial and precious metals, agriculture and livestock, giving the index ample exposure to all the commodities sectors. These characteristics mean the index provides exposure to the economic cycle without a heavy weighting the energy sector, which may give the index excessive geopolitical risk exposure. Such an index still should be actively traded and have significant liquidity.

Another way of getting exposure to commodities is through commodity-linked notes. In its simplest form, a commodity-linked note is an intermediate-term debt instrument whose pay off is a function of value of the underlying basket of commodities futures contract. Commodity-linked notes have several advantages, such as automatic rolling of underlying futures contracts, complete transparency, and viable exposure to the asset class for investors facing restrictions on investing in the commodities market. Some commodity-linked notes, however, may require investors to assume counterparty and liquidity risks.


What can investors expect when they incorporate commodities in a more broadly diversified portfolio? Consider one asset allocation exercise designed to find the best combination of stocks, bonds and such alternatives as hedge funds, private equity and real estate with commodities, using expected return forecasts for each asset class in a portfolio optimization model.

The answer is that adding a commodities-futures index to a portfolio has the potential to reduce risk for most portfolios. (See “Efficient Frontier,” this page.) Thus some trust portfolios might consider commodities a strategic asset class that is suitable for their overall asset allocation.


Will commodities' risk and benefits endure or are they merely transitory? Compelling evidence suggests that commodities' out-performance is the result of a secular shift in the global economy. The key, driving force is a soaring demand for raw materials as China and India converge with the developed economies of the world.

What is also apparent is that, even after the across-the-board increases in commodity prices since 2001, companies have been slow to plan new production capacity. Expert estimates5 see the demand for most industrial commodities rising substantially during the next several years. (See “Global Pressure,” p. 35.) They also predict that the supply-demand balance for several key commodities, such as aluminum and zinc, will shift from surplus to shortage in the next several years, even after taking into account additions in commodity processing facilities either underway or already planned. Based on these supply-demand dynamics, current commodity prices may not fully reflect the future demand for commodities and are likely to be pushed higher.

What may prove unique about this cycle is the fact that commodity prices are rising far faster than the overall rate of inflation. The reason for this seeming dichotomy is that while the dramatic growth seen in China, India, Russia, Brazil and the rest of the developing world is boosting the demand for raw materials — the integration of their workforces via outsourcing is reducing the cost of the labor component in the global supply chain. Because labor costs represent such a large portion of the total costs of a product, the declining labor cost component can outweigh the effects of increased commodity prices, preventing a sustained rise in overall inflation. The strength of these dynamics creates a set of conditions in which commodity prices could continue to rise even if inflation in the United States remains between 3 percent and 4 percent a year.


The lack of correlation between stocks and bonds is likely to persist based on their fundamental differences and historical behaviors. The expected rise in commodity prices does not mean that the commodity price cycle — which is driven by the business cycle — will change.

The reason for this lack of correlation is rooted in the fundamentally different demand dynamic for financial assets and commodities over the course of the business cycle. Using dates set by the National Bureau of Economic Research, we can map the relative returns and return correlations between stocks, bonds and commodities during various phases of the business cycle.

Demand for stocks tends to be anticipatory. Investors tend to bid up stocks late in the recessionary cycle and early in the expansionary cycle, boosting the returns for equities at a time when actual signs of growth have yet to emerge. But the demand for commodities is weakest in the periods of late recession and early expansion — and this is when their returns tend to be weakest. These underlying differences in demand patterns mean that the lack of correlation between stock returns and commodity returns is rooted in the fundamentally different behavior of hard assets and financial assets throughout the course of the business cycle. (See “In Good Times and Bad,” this page.)

The fundamentally different characteristics of commodity assets and financial assets as well as the long history of this counter-cyclical behavior are compelling reasons why commodity investment should continue to provide valuable diversification benefits.

Investors seeking returns from non-traditional asset classes are turning to investments in commodities for many reasons. Well-chosen commodity investments offer the potential for attractive returns and low correlation with stocks, bonds and such alternative investments as hedge funds, private equity and real estate. Having recovered strongly from the lows of 2001, commodity prices are benefiting from robust demand driven by the industrialization and urbanization of India, China, Brazil, Russia and other developing economies of the world. These trends may be part of a secular growth shift in the global economy that could continue to support demand for commodities for a number of years.

Given the fact that commodities respond in fundamentally different ways to economic and financial trends than stocks and bonds, the counter-cyclicality between commodity prices and stock and bond prices is likely to continue for the foreseeable future. For all of these reasons, fiduciaries might consider a strategic allocation to commodities as a part of their trust investment portfolios.

Douglas Moore, head, Estate and Charitable Planning, The Citigroup Private Bank, Muhammad Lawai, analyst, U.S. Investment Analytical Lab, The Citigroup Private Bank and Leland Montgomery, head of Content Development, The Citigroup Private Bank, contributed to this article.

The Citigroup Private Bank (CPB) is a business of Citigroup Inc. (Citigroup), which provides its clients access to a broad array of products and services available through bank and non-bank affiliates. Not all products and services are provided by all affiliates or are available at all locations.

This article is for informational purposes only and does not constitute a solicitation to buy or sell securities. Opinions expressed are those of the author, and may differ from the opinions expressed by departments or other divisions or affiliates of Citigroup. Although information in this article is believed to be reliable, Citigroup and its affiliates do not warrant the accuracy or completeness and accept no liability for any direct or consequential losses arising from its use and do not provide tax or legal advice.

The investment strategies outlined in t his article involve inherent risks and are not appropriate for every investor. Investors should refrain from entering into transactions in futures contracts unless they fully understand the terms and risks of the transactions, including the extent of potential risk of loss, which can be equal to, or in certain instances greater than, the full amount of the intitial investment.


  1. Because most commodity index price histories go back only to the 1970s, it's necessary to draw on a customized index of commodity prices created by Gary Gorton of the University Pennsylvania and K. Geert Rouwenhorst of the Yale School of Management. Gorton is the Robert Morris Professor of Banking and Finance at the Wharton School, University of Pennsylvania, and a research associate at the National Bureau of Economic Research. Rouwenhorst is professor of finance and deputy director of the International Center for Finance at the School of Management, Yale University. The index uses data compiled by the Commodities Research Bureau (CRB). This index gives an equal weighting to a broad basket of commodities, starting with eight commodities in 1960 and growing to 36 commodities by 2006.
  2. Gary Gorton and K. Geert Rouwenhorst, “Facts and Fantasies About Commodities Futures,” Financial Analysts Journal, March/April 2006.
  3. Whereas commodity futures are leveraged, these indexes are unleveraged. Commodity futures typically allow the purchase of $1 of commodities with only a small amount of equity, for example 10 cents of margin account equity. The indexes are constructed to remove that leverage, by the following method: for every $1 of investment in the index, 10 cents is invested in commodities futures while 90 cents is invested passively in three-month Treasury Bills. This eliminates the effects of leverage and simulates actual commodities investing — where excess cash funds are typically invested in interest-bearing securities.
  4. Expected returns are no guarantee of actual results. Expected returns of the indices mentioned are forecasts by the Global Wealth Management Group (GWM) at Citigroup of the expected returns for the specific asset classes (to which the index belongs) over a long-term, that is to say a 10-year time horizon. These forecasts are made using a proprietary methodology using historical returns of the specific asset classes. Market information such as “return to fair-value” in the case of equities and capital gains/losses for bonds are incorporated in the return expectations.
  5. Citigroup Investment Research. Investments are not bank deposis; are not insured by the FDIC or any o ther governmental agency; are neither obligations of, nor guaranteed by, Citibank/Citigroup or any of their affiliates; and are subject to investment risks, including possible loss of the principal amount invested.

An Efficient Investment

Equally weighted commodity-futures index has exhibited attractive risk-return characteristics

Higher Sharpe ratio implies that the investment is more efficient
Comparative Return, Volatility and Sharpe Ratio (Jan ‘60 - Dec. ‘05) Annualized Return Volatility Sharpe Ratio
Equally Weighted Commodities-Futures Index 10.7% 12.0% 0.43
Equities (S&P 500) 10.4% 14.7% 0.33
Bonds (LT Govt/Corp. Index) 7.5% 8.9% 0.22
Equally weighted commodity-futures index has been uncorrelated with most asset classes
Asset Classes Commodities*
Commodities* 1.00
Equities (S&P 500) 0.05
Bonds (LT Govt/Corp.) -0.14
Non-directional HF -0.01
Directional HF 0.09
Private Equity 0.06
Real Estate 0.13
Note: Past performance is not indicative of future results. Actual results may vary Data Sources: National Bureau of Economic Research, Ibbotson Associates, National Council of Real Estate Investment Fiduciaries, Venture Economics, Hedge Fund Research


Understanding how commodities affect a portfolio involves constructing a series of efficient portfolios that offer the highest expected return for a given level of risk. “Efficient Frontier,” this page, shows the expected total annual returns for different mixes of asset classes over the long term — that is, 10 years — based on the expected returns of each asset class, developed by Citigroup Global Wealth Management. The line that connects the various risk and return combinations is the efficient frontier, meaning the set of portfolios that has the maximum expected rate of return for every given level of risk.

For our study, we first constructed the most efficient hypothetical portfolios consisting solely of traditional assets (stocks, bonds and cash) using our strategic forecasts of a 9.8 percent annual expected return for equities, and a 4.8 percent expected return for bonds and cash. We then examined the impact on risk and return measures of adding a commodity futures index to this portfolio. Although historical commodity-futures index returns have averaged 10 percent a year (See “An Efficient Investment,” p. 32), we use a more conservative forecast of future returns of 8 percent. Our optimization process also reflected our lower level of confidence in the returns on commodity-futures indexes relative to returns on stocks and bonds. Although not shown in the chart, optimization studies were also done at expected annual returns of 4.8 percent and 7 percent for commodities-futures index, which provided lower expected portfolio returns.

Finally, we incorporated alternative asset classes (hedge funds, private equity, and real estate) into this combination of commodities and traditional assets to evaluate how this addition would affect an investor's expected risk and return. In each case, adding a commodity-futures index to the portfolio (allocations to commodity-futures index ranged from 3.5 percent to 10 percent) increased the expected return for a given level of risk, as shown in the three efficient frontiers. See “Efficient Frontier,” this page. (Note that it may be inefficient to add a commodities-futures index to a portfolio of traditional assets if expected returns on commodities is lower than expected return on cash.)