Commodity index investing can provide an excellent counterbalance to the volatility of stocks and bonds, bringing both diversification and lower risk to an investor's portfolio
With investors today faced with lower projected returns from conventional asset classes and a heightened sensitivity to risk, they are far less willing to tolerate negative or volatile performance from standard relative return funds.
Instead, many are now seeking absolute return strategies that aim to deliver attractive risk-adjusted returns and provide diversification away from stock and bond market volatility. One way to pursue this goal is by increasing a portfolio's exposure to assets whose returns are less correlated to the broader market. In search of such investment vehicles, which zig when the stock and bond markets zag, investors are turning increasingly to alternative investments such as private equity and hedge funds.
However, most alternative investments come with a number of attributes that can sometimes reduce their appeal (see table one below). For example, despite their growing popularity, some hedge funds suffer from low degrees of transparency and fees that can exceed 2% of invested capital, plus 20% of profits. But, more importantly, some of these vehicles may not even provide the kind of diversification away from the broader market that investors seek.
Real Asset Alternatives
Real assets, on the other hand, march to the beat of a different economic drum, as their value moves up and down in direct relation to the current forces of supply and demand. Commodities - metals, oil and gas, agriculture and livestock - enable an investor to hold positions that move with the prices of most real assets, raw and finished, throughout the entire global economy. In doing so, they act as a counterbalance to financial assets, being particularly effective in diversifying a portfolio away from its mainstream holdings in stocks and bonds. In addition, unlike stocks and bonds, commodities are referred to as real assets because they behave differently in an inflationary context, offering an effective hedge for investors sensitive to periods of increased inflation.
However, getting such exposure can present a formidable challenge. Buying commodities directly is simply unrealistic while the stocks of commodity-producing companies are rarely pure plays on the raw materials they produce.
One method that is gaining increasing attention from investors is to buy exposure to a diversified, passive index that is transparent and cost effective. The major commodity indices provide efficient price exposure to a cross section of the principal raw and semi-finished goods used by the world's producers and consumers. These indices measure the return that an investor would get by consistently holding long positions in a broad range of futures contracts on the underlying commodities (see table one).
Investing in a Commodities Index
One of the broadest and most liquid commodity indices is the Goldman Sachs Commodity Index (GSCI). The GSCI is composed of contracts on 26 different commodities weighted according to the physical quantity of world production. That is, the percentage of a given commodity is determined by its average production during the last five years.
The primary objective of investing in an index composed of many commodities is pure diversification, and this the GSCI provides. The prices of individual commodity components within the index remain subject to their unique supply and demand forces, but correlation among the returns of individual commodities is low and, as a result, volatility is reduced.
A look at the 34-year history of GSCI reveals some interesting performance characteristics, particularly when it is overlaid onto a traditional portfolio. For example, of the 34 years, only two had negative returns for both the GSCI and stocks. In every other year, gains in one asset class either enhanced the returns or mitigated the losses of the other. That is, stock market declines generally were offset by increases in the GSCI index for an investor holding both types of assets. In fact, commodity returns often proved strongest when stocks were weakest (as in 1974, 2000, and 2002). In addition, no year showed negative returns for both the GSCI and bonds, suggesting the GSCI may be an even better diversifier for bonds than for stocks.
Regardless of the time period studied, whether it includes only the boom in oil prices in the 1970s, the period of declining inflation in the 1980s, or the entire history of the GSCI, the addition of commodities would provide a significant reduction in overall risk for a conventional portfolio in every period (see table two).
Commodities - The Great Diversifier
The extent to which commodities move against the grain of most financial assets can be seen directly by examining the relative correlations of the various asset classes. Financial assets historically have exhibited relatively high correlation with one another. Over the period 1976-2004, for example, US large-cap stocks had a strong positive correlation with US small caps (0.80), foreign equities (0.54), and even bonds (0.26) (see table three).
But the risk and return characteristics of commodities display little or no connection with those of financial assets. Commodities, as represented by the GSCI, exhibit lower correlations with large-cap stocks (0.03), foreign stocks (0.10), small caps (0.08), and bonds (-0.03) than any other asset class. It is this random behaviour of commodities relative to the standard asset classes that produces their unusually strong "diversification effect" on almost any traditional portfolio.
And therein lies the long-term strategic value of commodities indices for most investors. For a critical factor to consider when adding any investment to a portfolio of assets is how it interacts with each of the other assets in the portfolio. In this regard, commodities appear to be the element that best complements many traditional portfolio components. Given the degree to which commodity indices move against the grain of the broader market, the addition of a basket of commodities to any traditional portfolio will expand the bounds of its efficient frontier. This potentially provides the same or better returns, while helping to reduce exposure to the volatility of the financial markets (see graph above).
a Complete Portfolio
Even a cursory glance at the world's business headlines would show that we are in the midst of a bull market for commodities. While the recent enthusiasm has cast an overdue spotlight on commodities, it has also obscured for many the true value of this unique real asset. Diversification is what commodities primarily bring to a portfolio. They are the 'yin' that complements the 'yang' of so many other potential portfolio components, helping to hedge away exposure to traditional market movements. Understood from this strategic point of view, commodities can offer the real asset alternative that many investors seek in their pursuit of positive, uncorrelated returns. A broad basket of these basic raw materials-accessible through a commodity index may be among the most versatile elements of any strategic allocation plan. Commodities may be the asset class that can most effectively complete a portfolio, regardless of passing economic conditions.
Commodities act as a counterbalance to financial assets, being particularly effective in diversifying a portfolio away from its mainstream holdings in stocks and bonds.
Diversification is what commodities primarily bring to a portfolio.
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