The TSP is an excellent investment vehicle for stocks and bonds. But if you have another investment account, like an IRA or taxable account, then holding some other asset classes can further diversify your wealth and provide you with more protection through all market conditions.
Back in March, I wrote about how to complement your TSP with other asset classes, and this article will zoom in on one asset class in particular: commodities producers.
Commodities: Usually A Late-Cycle Outperformer
Research by Fidelity Investments has shown that in 8 out of 10 of US business cycles, commodities (specifically, energy and materials producers) outperform the S&P 500 during the late stage of the cycle:
This is because in the late stage of a business cycle, the economy tends to overheat and inflation starts to kick in, which directly benefits many types of commodity producers. Of course, every business cycle is a bit different, which is why commodities don’t outperform 100% of the time.
As you can see in JP Morgan’s chart below, commodity prices are strongly correlated with inflation:
So, if you expect higher inflation, then having commodity exposure makes sense, and can serve as a nice hedge against high inflation. If you expect low inflation, then commodities might not be the best bet.
Currently, global commodity prices are low across the board compared to their 10-year averages:
In fact, in an otherwise highly-valued market for stocks and bonds and real estate, commodity indices are about one standard deviation below their averages, which is very significant.
Energy prices have been low for a few years now due to increasing American gas and oil production, which has impacted the global supply/demand balance. Food prices have been low due to a variety of factors, including a decreasing growth rate of biofuel usage, and decreasing population growth rates in major population centers like China, and decreased energy prices and other expenses. Weather also plays a major role in food shortages or food oversupply.
While it remains to be seen what commodity prices will be going forward, even a partial return to the mean would result in solid gains for commodity producers.
The big bear argument against higher energy prices over the long term is that increasing solar energy capacity, lower solar per-watt prices, and increasing use of electric vehicles will permanently reduce energy prices. A bull argument is that there may be one more surge in energy prices before a long-term decline in demand really kicks in.
And a bear argument against food prices over the long term is that with slower global population growth and less of a focus on biofuels, there might not be any strong catalysts for higher food prices. On the other hand, the bull argument is that with global warming and increased rates of drought, a finite supply of arable land in the world, and still-increasing population, food and fertilizer prices should move upward.
One of the major bull arguments for industrial metal prices over the long-term, especially rare earth metals, is that with a shift from gasoline-powered vehicles to electric vehicles, demand for rare earth metals will increase. Due to their massive batteries and other pieces of technology, electric vehicles use far more rare earth metals than gasoline-powered vehicles. A world with hundreds of millions of electric vehicles is a world with much higher demand of rare earth metals.
The neutral position for diversification is just to hold some commodity producers as small part of a portfolio, to have exposure and spread your bets out.
How to Invest in Commodities
You can invest in commodities directly, or you can invest in the businesses that produce commodities.
The easiest way is to hold a small position in a broad commodity producer exchange-traded fund (ETF), such as the FlexShares Morningstar Global Upstream Natural Resources ETF (ticker: GUNR) or the SPDR S&P Global Natural Resources ETF (ticker: GNR).
If you want to target a specific area, then more focused ETFs like the iShares MSCI Global Agriculture Producers ETF (ticker: VEGI) or the iShares MSCI Global Metals and Mining Producers ETF (ticker: PICK), could be bought. And of course if you want to get down to the fine details, individual stocks can be purchased.
Investors that want a hands-off investment approach don’t really need this level of diversification. Holding broad stock indices, bond indices, and perhaps some real estate, is more than enough in most cases. The TSP equity funds do already have some energy and materials exposure, just not a lot.
On the other hand, investors that want a more hands-on approach, want to benefit during different parts of the business cycle, want more inflation protection, or that want broader diversification in partially uncorrelated asset classes, may benefit from holding other asset classes as part of their IRAs or other accounts.
Small holdings in precious metals, commodity producers, emerging markets, and real estate are all decent ways to complement your TSP holdings because the TSP has relatively little exposure to them.