Recency bias is a powerful emotion that leads investors to focus on investing in what is working right now, resulting in the over-allocation to outperforming asset classes and abandonment of recent laggards. This performance chasing leads to poor long-term performance and is counter to our multi‑asset class investing discipline.
The past decade has been extremely difficult for investors in natural resources. The asset class has consistently underperformed equity markets and trailed the returns of other asset classes. In spite of these performance headwinds, we remain committed to investing in natural resources as a key asset class in our investment portfolios. We believe performance will reverse in the coming years and investors will benefit. Supporting this outlook is our confidence that the strength in the U.S. dollar will eventually abate, that negative sentiment towards the asset class today represents an opportunity, and that natural resource performance will revert towards longer-term trends.
Natural resource returns are strongly correlated to gains and losses in the U.S. dollar. The following scatter plot on the left shows the strong negative correlation between changes in the U.S. dollar and the corresponding change in natural resources (Bloomberg Commodities Index) over the past 20 years. Analysis of this trend indicates that about 50% of the variation in natural resource returns is explained by moves in the U.S. dollar. Since 2000, a 1% increase in the U.S. dollar has generally resulted in a greater than 1% decline in natural resources. As shown in the chart on the right, the 35% gain in the U.S. dollar since early-2011 has created a significant and persistent headwind for natural resources over the same period. We believe that U.S. dollar strength will eventually abate and natural resources will be one of the largest beneficiaries.
In reaction to this underperformance, the market sentiment for natural resources is as low today as it has been at any time over the past decade. Over the past year, investors have reduced their investments in non-precious metal natural resource mutual funds and ETFs by nearly a third. This dramatic shift in fund flows over the past year is noted in the chart below. We believe that periods of extremely negative sentiment can be a reflection of recency bias overtaking rational decision making. And in this case, we believe that such negative sentiment bodes well for future returns.
The recent underperformance of natural resources could reverse quite dramatically. Natural resources have experienced similar periods of underperformance previously which were followed by subsequent periods of dramatic outperformance. From late-1992 to early-1999, natural resources trailed the S&P 500 by almost 70% – similar to the current underperformance since 2011. However, from 1999 to mid-2008, natural resources outperformed the S&P 500 by a factor of five.
This quarter we slightly increased our weighting to natural resources and adjusted our holdings. To reduce the correlation of our natural resources with U.S. and global equities and increase our exposure to pure commodity prices, we reduced our holdings of individual natural resource companies and increased our future-linked natural resource exposure by purchasing futures backed exchange traded notes. After this change, our current natural resource exposure is about 30% energy, 30% agricultural, 15% precious metals, and 20% base metals. We believe this approach improves the diversification benefits of natural resources and positions our portfolios to benefit from the reversal in natural resource returns we expect.
As means of underperforming asset classes, such as natural resources, revert to their long-term return profiles, our multi-asset class portfolio should perform well. While timing is uncertain, we believe that the decade-long rally in U.S. equities and real estate is reaching its zenith and in the coming years their performance will trail other asset classes. As a result, investors who are over-allocated to U.S equities and real estate at the expense of other asset classes will see the downside of lacking diversification and performance chasing.
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