In the ever-evolving landscape of investments, commodities often remain an overlooked asset class for many investors. At KeyGlass Capital, we advocate for the inclusion of commodities in a well-rounded trend-following investment strategy.

Diversification is Key The recent market turmoil, marked by double-digit declines in global equities and bonds in 2022, has shifted the investment landscape. We’ve departed from the era of benign low inflation and low-interest rates that defined the 2010s. As we step into 2023, investors find themselves pondering the endurance of inflation, the pace of central bank rate hikes, and the potential global economic ramifications of tighter monetary policies.

The resurgence of inflation challenges traditional portfolio construction. Bonds, once a staple, now offer negative real returns. Meanwhile, commodities are gaining renewed attention due to their strong performance in the post-pandemic world and their historical ability to deliver returns during inflationary periods.

Data supports the case for investing in commodities as a hedge against inflation. Over the years, when U.S. Consumer Price Index (CPI) exceeded 3%, the S&P GS commodity index has provided an annualized real return of 4.9% since 1972, compared to a meager -0.4% real return for the MSCI World stock index.

The Complex Nature of Commodities However, it’s worth noting that investing in commodities can be a challenging endeavor. The S&P GS commodity index currently sits more than 60% below its 2008 highs, and despite its attractive returns in the 1970s and 1980s, investors would have weathered two substantial drawdowns of over 30% during this period. This volatility during inflationary periods is evident in the chart below, which traces the price movements of four major commodities dating back to 1960.

Embracing Dynamic Approaches To address the inherent volatility of commodities, more dynamic investment approaches are required. Trend-following investment strategies, with their historical success in generating returns from commodities, offer a potential solution. These strategies have a track record of performing well during times of high inflation, as exemplified by their impressive 27.3% return in 2022, a challenging year for traditional stock and bond investments.

Trend-following entails taking long positions in markets trending upwards and short positions in those trending downwards, with the anticipation that these trends will continue. When a trend reverses, the strategy adapts by reducing its position and changing direction.

This approach proves particularly appealing in the world of commodities, where sustained price trends are evident. By engaging in trend-following strategies, investors can access the upside potential of commodities while also profiting from downward trends. By positioning themselves to benefit from trends, whether upward or downward, across various commodities, trend-following strategies provide an effective means of capturing diverse price swings within the asset class.