Historical Natural Resources & Commodities Investing – Post COVID-19 Crisis

Investors have long turned to commodity and natural resource investing as a potential source of diversification, inflation hedging, and capital appreciation. However, commodities—and notably natural resources—are currently slightly out of favor with investors. Is this market sentiment here to stay?

On a recent episode of our Funds in Focus podcast, we spoke with Senior Investment Strategist Mark Carlson about how commodities investing has changed over time, how it has come to be out of favor with investors, and whether it could be poised for a rebound.

COMMODITY FUTURES INVESTING HAS ITS DRAWBACKS

From the early days of trading, commodity futures were the go-to vehicle for commodities investing. However, as access to commodities futures became easier through investing tools such as exchange-traded notes (ETNs) and more investors used them for core allocations, correlations rose between commodities futures and equities. In effect, diversification benefits diminished.

The structure of commodities futures contracts can also make them problematic for long-term strategic allocations. This is because investors must continually roll from expiring futures contracts into longer contracts to maintain the allocation. And if the price of the longer contract is higher than the spot price, then the investor must reinvest in the futures contract at a higher price. This is known as negative roll yield, which can effectively erode returns.

NATURAL RESOURCE EQUITIES CAN BE A SOLUTION—BUT THE INDEX MATTERS

Unlike commodities futures contracts, natural resource equity investments don’t run the risk of negative roll yield. They have also historically benefited from compensation for the equity risk premium and can generate income through dividend distributions. Further, natural resource equities and can offer the opportunity for broader, more diverse exposure to natural resources where futures are not available.

However, one of the historical drawbacks of natural resource equities is that some legacy indices often provide inefficient sector exposure and may have weaker than expected correlations to inflation. And because these indices have long performance track records, many investors continue to use them. Newer natural resource indices—like the Morningstar Global Upstream Natural Resource Index—can correct for these shortcomings.

COMMODITIES AND NATURAL RESOURCES ARE OUT OF FAVOR—BUT THE INDEX STILL MATTERS

As the COVID-19 crisis roiled markets, both commodity futures index and natural resource equity performance plummeted, taking a harder hit than broader equity markets. Global lockdowns at the onset of the crisis—and again being imposed as we’ve seen a resurgence of cases—stifled demand, particularly in the energy sector. And since commodities and natural resources tend to thrive in a fully employed and globalized economy, they continue to be out of favor with investors as the pandemic crisis and its economic impacts persist.

But while commodities and natural resources equity returns were negative across the board, year-to-date through July 2020 they varied across indices. We also observe variation across 5-year annualized returns, underscoring why commodities and natural resources index selection matters.

total returns

* YTD Total Returns are for the time period of 02 January 2020 – 31 July 2020

** 5- Year Annualized Returns are for the time period of 01 August 1995 – 31 July 2020

STANDARDIZED total returns

* YTD Total Returns are for the time period of 02 January 2020 – 30 June 2020

** 5- Year Annualized Returns are for the time period of 01 July1995 – 30 June 2020

Performance data quoted represents past performance and does not guarantee future results. Investment return and principal value of an investment will fluctuate so that an investor's shares, when redeemed or sold in the secondary market, may be worth more or less than the original cost. Investors will incur usual and customary brokerage commissions when buying or selling shares of the exchange-traded funds ("ETFs") in the secondary market, and that, if reflected, the brokerage commissions would reduce the performance returns. Current performance may be lower or higher than the performance shown. For the most recent month-end performance, please visit the Fund's website at www.flexshares.com or call 855-353-9383 for more information.

Please see our FlexShares Morningstar® Global Upstream Natural Resources Index Fund (GUNR) for more information on our global upstream natural resources ETF, including the most recent month-end and quarter-end performance.

CAN THE SECTOR STAGE A COMEBACK?

There are many uncertainties when it comes to what the post-COVID-19 world looks like and how it will impact commodities and natural resources demand. Some of it hinges on China’s economic recovery, as the country is the largest consumer of most industrial metals. If China can continue its progress toward a more developed economy, this would drive higher demand for commodities.

The pandemic has given rise to increased work from home lifestyles, which could impact commercial real estate and in effect construction materials. More time spent at home could also continue to cut into demand for energy.

However, while the end date of the crisis remains unknown, US and global economies will ultimately recover and demand for raw materials should return. And should historical trends continue, commodities and natural resources could continue to offer the potential for income, inflation hedging, and capital appreciation.

DEFINITIONS

Morningstar Global Upstream Natural Resources Index measures the performance of stocks issued by companies that have significant business operations in the ownership, management and/or production of natural resources in energy, agriculture, precious or industrial metals, timber and water resources sectors as defined by Morningstar’s industry classification standards.

S&P Global Natural Resources Index includes 90 of the largest publicly-traded companies in natural resources and commodities businesses with exposure across 3 primary commodity-related sectors: agribusiness, energy, and metals & mining.

Bloomberg Commodity Total Return Index tracks prices of futures contracts on physical commodities on the commodity markets. The index is designed to minimize concentration in any one commodity or sector. It currently has 23 commodity futures in six sectors. No one commodity can compose more than 15% of the index, no one commodity and its derived commodities can compose more than 25% of the index, and no sector can represent more than 33% of the index (as of the annual weightings of the components).

IMPORTANT INFORMATION 

FlexShares Morningstar^® Global Upstream Natural Resources Index Fund (GUNR) is subject to the global natural resource industry. As the demand for or prices of natural resources increase, the Fund's equity investment generally would be expected to also increase. Conversely, declines in demand for or prices of natural resources generally would be expected to cause declines in value of such equity securities. Such declines may occur quickly and without warning and may negatively impact your investment in the Fund.