Accept No Substitutes: Why Natural Resources Stocks Are a Horrible Way to Get Commodity Exposure
Investors have historically held an allocation to commodities in order to tap the inflation fighting or diversifying properties of this asset class. While the most natural way to get this commodity exposures by investing in a portfolio of commodity futures, a common argument by investors is that these benefits can be more easily accessed by owning a portfolio of natural resource stocks. The logic behind this position typically includes the notion that the largest driver of the prices of these stocks is the price level of their underlying commodity (e.g. an energy company’s share price is largely driven by the price of crude oil).
However, this intuitive argument has not historically held. In fact, price movements of natural resource stocks exhibit dramatically different return patterns from their associated commodity. Also, compared to an exposure to commodity futures, natural resource stocks demonstrate higher levels of correlation with the equity asset class while exhibiting significantly greater levels of volatility.
These price movements and higher volatility have important ramifications for the expected risk and return of an investor’s portfolio. All in all, the intuitively appealing substitution of natural resource stocks for a futures-based commodity exposure results in a less effective solution for both inflation protection and diversification.