The case for commodities as an inflation-hedging asset is based on the tendency for inflation to translate into higher prices for raw materials like oil, natural gas, metals, and agriculture products. Yet broad-based inflation is just one of the factors that drive commodity prices. At any time, other macroeconomic factors and specific supply and demand issues can either hurt or help different commodities and natural resources.
Just as diversification helps manage portfolio risk and returns across asset classes, diversification within the commodity and natural resources universe can help improve inflation-hedging strategies. While many ETFs and mutual funds rely on a futures-based strategy that buys short-term commodity contracts, FlexShares believes there’s a more efficient way to gain diversified commodity exposure for inflation protection: Using an equity-based strategy that invests in companies that own and develop natural resources.
Our research shows that:
Rising inflation reflects a general increase in prices across the economy. While commodities as a category historically have maintained their value in inflationary environments better than other asset classes, the performance of individual commodities can vary based on other forces that affect certain sectors of the economy or types of raw materials.
Consider oil futures, which are commonly held as a hedge against inflation — especially during an economic expansion. In today’s economy, the shift toward electric vehicles (EVs) may reduce demand for gasoline in the coming years and put downward pressure on oil prices. At the same time, technological innovations in the auto industry are benefiting other natural resources like metals, given that EVs use anywhere from two to three times as much copper as cars with internal combustion engines.i
One of the best ways to hedge against inflation while addressing sector – or commodity-specific trends is to look for strategies that invest in a diversified basket of natural resources, including:
An equity-based strategy that invests in companies that own, harvest, or extract natural resources provides exposure to assets that aren’t widely traded — or aren’t available at all — on the commodity futures markets, like timberland and water. An equity-based strategy also avoids the complex and volatile nature of investing in futures contracts, which requires strategies to continually replace expiring contracts with new ones at potentially higher costs.
One challenge for equity-based natural resources strategies is that the same inflationary pressures causing raw materials prices to rise also could increase the costs for companies that process, transport, or distribute finished products. The simple solution for this problem is to focus on the right part of the natural resources supply chain.
To capture the impact of rising commodity prices, an equity-based strategy can focus its investments at the start of the natural resources supply chain. This is where companies extract commodities like timber, metal ores, and fossil fuels from the ground. FlexShares calls this the “upstream” portion of the supply chain.
Upstream companies’ revenues, earnings, cash flows, and, therefore, valuations tend to be more correlated to the price movements of their natural resources. Downstream companies, on the other hand, are often “takers” of natural resources prices and face challenges associated with processing, refining, packaging, and distributing natural resource–based products, which can negatively impact margins and valuations resulting in lower correlation to inflation pressures from natural resources prices. Investing in upstream companies also may provide capital appreciation and income potential that’s not available in a strategy that invests in futures contracts.
Combining diversification options available in an equity-based natural resources strategy with a focus on the upstream portion of the supply chain may better position a strategy to capture the inflation-hedging qualities of commodities — without the complexity and concentration risks of a futures-based portfolio.
For more ideas on adding inflation-hedging components to investment portfolios, read:
For more information on FlexShares’ approach to natural resources investing, see our Fund page:
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