In the paper Commodity Investing and Its Role in a Portfolio, Anatoly Shtekhman, head of global advised portfolio construction, Fei Xu, head of alternative and multi-asset investments in Vanguard Quantitative Equity Group (QEG), Victor Zhu, senior investment strategist in the Investment Strategy Group, Ziqi Tan, investment strategy analyst in the Investment Strategy Group, and Stefan Sevi, assistant portfolio manager in QEG, explore the three primary functions of commodities: diversification, returns, and hedging against unexpected inflation.

Inflation isn’t an entirely unanticipated occurrence. Forward-looking financial markets expect a certain level of inflation and factor it into the asset prices they set. It’s when markets are shocked by unanticipated events—say a surge in energy prices or persistently high demand for goods—that unexpected inflation occurs. And those elevated levels of inflation can erode investor portfolios.

Unexpected inflation can be particularly damaging for retirees or other investors with a short-term investment horizon.

To combat such risks, several portfolio strategies can provide investors with strategic exposure to inflation-sensitive assets. These include Treasury inflation-protected securities (TIPS) and commodities.

“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,” said Xu. “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.”

Commodities tend to behave differently than traditional asset classes, especially when commodity price shocks are driven by unexpected changes in supply. (Consider the impact of wheat and oil disruption after the Russian invasion of Ukraine, or the extended shutdown of Chinese factories amid a long-standing national zero-COVID policy.) Vanguard research found that commodities had an inflation beta that fluctuated between 6 and 9 over the past three decades, the highest among all the asset classes the authors examined. This suggests that a 1% rise in unexpected inflation would produce a 6% to 9% rise in commodities. In short, a small yet strategic commodity position can offer an outsized safeguard for an overall portfolio.

“There is no silver bullet to fight inflation, but if short-term inflation hedging is the goal, historically, commodities have been an excellent choice,” said Shtekhman.

That said, it’s worth noting that commodities aren’t the only tool in the inflation-fighting toolbox, especially for investors with a longer time horizon. They may be better served by a more traditional mix of stocks and bonds, where equity risk premium will likely outpace inflation and deliver real return over longer time periods.

TIPS are commonly used as inflation fighters but can be limiting in terms of capital efficiency. They have a relatively low inflation beta, which means that only the TIPS portion of a portfolio is inflation-hedged. An allocation to commodities, meanwhile, can hedge a significant amount of a portfolio, even beyond the commodity portion. “A small addition of commodities can be a more efficient diversifier than the addition of TIPS, which means the rest of your portfolio can be unlocked to pursue other strategic initiatives,” said Shtekhman.

The energy sector also has a significant relationship with unexpected inflation, which makes it another commonly used inflation hedge. However, in addition to its very high correlation (beta) with the broad equity market, the sector also has the potential for idiosyncratic company risk (an accident on a drilling platform, for example), variations in corporate capital structure and management quality, and other factors that can mute the full impact of the relationship.

While the optimal percentage of commodities will vary based on different inflation environments, economic conditions, and investor risk tolerance, a large position isn’t needed to build an effective hedge against inflation. The following examples show how commodity allocations can change in differing inflation conditions, as constructed by the Vanguard Asset Allocation Model (VAAM) in combination with time-varying asset return expectations as generated by the Vanguard Capital Markets Model ™ (VCMM). As inflation rises, so does the allocation to commodities.

Investing always has trade-offs and risks, but the authors maintain that commodities can offer a short-term solution to the inflation problem. “When investing in commodities, you’re creating a tracking error against your strategic asset allocation to gain access to inflation hedging,” said Shtekhman.

Investors concerned about unexpected inflation can develop inflation-hedging goal-based portfolios with varying commodities allocations that respond to changing economic forecasts, as displayed above, or those that target a specific beta by using the Vanguard goal-based portfolio construction methodology. With either method, “a little bit of a commodity allocation can go a long way,” said Xu.  

• Vanguard economic and market outlook for 2023: Beating back inflation (61-page PDF, issued December 2022)
• Investing in a high-inflation world (video, issued May 2022)
• Portfolio construction: Principles inform possibilities (article, issued August 2022)