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Commodity futures can offer consistent returns, says Vanguard

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Commodity futures can offer diversification benefits for investors and have experienced long periods of significant returns, according to a paper by Vanguard.

The paper, titled Investment case for commodities? Myths and reality, demonstrates that there is little merit in the argument that relatively high long-term average returns for commodity futures are solely a result of a few brief abnormal periods of returns or commodity bubbles and that outside of these periods returns are unattractive.

One of the biggest challenges in understanding commodities as an asset class is the absence of a long historical data record, which Vanguard believes is vital to understand any asset class. Vanguard has therefore constructed a commodities return series representing the broad commodity market using historical commodity futures data beginning in 1959.

This historical analysis demonstrates that commodity futures have experienced long periods of significant returns for investors, as well as sequences of booms and busts similar to equities. For the period 31 August 1959 to 30 April 2009 commodity futures have produced an average annual return of 9.8 per cent, comparable to the nine per cent for US equities over the same period. The data shows that both commodities and equities have had multiple years of returns in the 20 per cent to 40 per cent range, yet equities have a higher volatility.

This analysis also addressed the potential diversification benefits of commodity futures. Historically, commodity futures returns and equity returns have had a very low correlation, and although this correlation has risen over time, recent data suggests that the correlation between commodity futures and equities is lower than that between other broadly accepted diversifiers such as global equities. 

The research shows that as with returns, diversification benefits are not dependent on a few historical periods. Adding commodity futures to a portfolio has the potential to reduce volatility. Taking a hypothetical example of two portfolios one with 100 per cent equity exposure and one with 80 per cent (60 per cent equities, 40 per cent bonds) and 20 per cent commodity exposure, the returns are comparable while the diversified portfolio potentially has 41 per cent less volatility.

In addition, while equities are leading indicators of the business cycle, commodity futures have tended to be lagging indicators and there is no reason to suggest that this relationship to the business cycle will change.

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