Executive Summary
- Commodities are often considered for their diversification benefits compared to traditional balanced compositions.
- A small weighting of 4%-9% of iron ore has historically increased Sharpe ratios by 7%-19%.
- Iron ore’s historically persistent backwardation provided excess returns.
Commodities’ Role as Diversifiers
Commodities, such as gold, crude oil and copper, have historically served as a potential hedge with low or negative correlation with traditional assets such as stocks and bonds. The ability for commodities to keep pace with inflation, while offsetting large negative returns from other asset classes during market stresses, has drawn more interest to explore the diversification benefits of alternative commodities. Iron ore, which is a key ingredient for steel production, has seen its physical market size grow in the past decade to become the second-largest commodity by value, only behind crude oil. Driven by steel demand from economies seeking to industrialize, iron ore became one of the leading global barometers for economic activity, attracting investors seeking exposure to this trend. This has fueled the growth of the futures market, which has grown in open interest and volume, attracting hedgers, speculators and financial institutions.
This paper seeks to describe the trade-offs between performance and volatility by including the S&P GSCI Iron Ore in a theoretical multi-asset strategy and to evaluate hypothetical performance over the past decade.
Performance Improvement through Commodities Weighting
We studied iron ore alongside other popular commodities such as gold, crude oil and copper. A hypothetical multi-asset strategy of 50% equities and 50% bonds was used for the purpose of this study. Equities are represented by the S&P 500® (TR) while bonds by the S&P 10-Year U.S. Treasury Note Futures Index (TR). The hypothetical performance of the studied commodities is calculated using the suite of S&P Total Return commodities indices. These Total Return indices are chosen as they comprehensively capture the price-return, roll-returns and collateral-returns of the underlying futures market.
