From the May 2006 issue of Wealth Manager Web • Subscribe!

May 1, 2006

Valuing Commodities

Commodities are the new "new thing" when it comes to tapping so-called alternative investments for improving the risk-adjusted performance of conventional stock and bond portfolios. But like so many asset classes beyond the mainstream--whether they're hedge funds, private equity or old Dutch masters--commodities come with their own peculiar glitch.

Analyzing the likes of oil, gold and wheat, either separately or collectively, is complicated and open to an even wider degree of interpretation than are stocks and bonds. Even those specialists who focus on commodities say there are precious few metrics for assessing raw materials on a valuation basis. Trying to decide if commodities are inexpensive, overpriced or something in between is virtually impossible by the standards that an MBA student would recognize as standard.

"Commodities per se don't lend themselves to a capital asset pricing model kind of framework," says Roger Gibson, author of Asset Allocation and president of Gibson Capital Management in Pittsburgh. "This is an asset class that's unlike stocks or bonds, which are traded on a valuation approach on the present value of the future cash flows."

If the lack of obvious methodologies for dissecting commodities is a deterrent for wealth managers, it's not immediately obvious. Asset growth has been strong for the expanding list of publicly traded funds targeting commodities. The oldest is a mutual fund, Oppenheimer Real Asset, which accumulated $1.9 billion in assets as of this past January since launching nine years ago. Several other commodities mutual funds have since joined the party, pulling in buckets of cash along the way, including the four-year-old Pimco Commodity Real Return Strategy, which reports more than $12 billion in assets. And the funds keep coming, including the February debut of the first commodities ETF in the U.S., the DB Commodity Index Tracking Fund. At least one more commodities ETF is in registration with the Securities and Exchange Commission as we write.

Although it's hard to know the extent to which wealth managers are using commodity funds in client accounts, the anecdotal evidence suggests that hard assets by way of a mutual fund or ETF wrapper are finding their way into strategic asset allocation plans. Never mind that the financial industry has relatively little experience in analyzing commodities; the strategy finds an eager audience.

"We've had a commodities allocation for two years," says Christopher Cordaro, chief investment officer at Regent Atlantic, a fee-only wealth management shop in Chatham, N.J. In fact, Regent doubled its strategic allocation to raw materials to 8 percent last October, he reports. The vehicle of choice has been Pimco Commodity Real Return Strategy, although Cordaro says he has started using the new commodities ETF.

The growing love affair with commodities in the financial community is partly driven by strong absolute and relative returns. Hot asset classes attract money, and commodities have clearly been hot, as suggested by the annualized five-year total returns through February 28, 2006 for commodities, stocks and bonds:

Commodities (Dow Jones-AIG Commodity Index) 10.31%

Bonds (Lehman Aggregate Bond) 5.42%

Stocks (Russell 3000) 3.57%

More of the same is coming in raw materials, predict commodity bulls. A familiar argument for expecting prices to keep rising centers on the advent of China, India and other emerging markets as major economic players on the global stage--a flowering that's expected to translate into a secular rise in the demand for commodities. Energy demand is especially topical among commodity bugs stories these days. By some estimates, finding new supplies of oil and natural gas to offset the escalating global demand will push prices higher over time.

Expecting strong capital gains in natural resources is only part of the asset class's appeal. A number of studies show that the historical performance of commodities over the long run is comparable to the performance of the stock market. At the same time, commodities post a low or negative correlation with stocks as well as bonds. It all adds up to the belief that putting commodities into the usual stocks/bonds/cash portfolio will boost returns while reducing risk.

Although there's a growing belief that commodities deserve a permanent role in asset allocation, as a practical matter there are questions when it comes to understanding the asset class. For starters, there's no standard process for benchmarking. In contrast to the stock market, where market capitalization is widely accepted for designing equity indices, measuring commodities is a task that's wide open for debate.

The debate is obvious when comparing the two most widely used commodities benchmarks--The Goldman Sachs Commodities Index (GSCI) and the Dow Jones-AIG Commodity Index (DJ-AIG). The GSCI's design is production weighted so that commodities produced in greater quantities receive a higher weight in the index compared to commodities produced in lesser amounts. Sounds good in theory, although not everyone agrees. The production-weighted approach minimizes gold's influence, for example. Since most of the gold mined throughout history is sitting in vaults, current production is relatively low. Yet the volume of gold trading is relatively high, a fact that when combined with the metal's monetary role as a store of value, makes a case for giving gold a bigger weight than current production warrants.

Although the DJ-AIG incorporates production data, the index emphasizes the liquidity associated with each commodity futures contract for choosing an index weight. "Liquidity provides a window on the commercial significance of a commodity," Dow Jones explains on its Website. In addition, DJ-AIG has a 33 percent cap on the weighting of any single category of commodities (energy, precious metals, grains, etc.)

Meanwhile, the DB Commodity Index Tracking Fund uses yet another methodology for building commodities exposure.

The result: different indices can post significantly different results. GSCI's energy weighting recently was about 74 percent, or more than twice the level in DJ-AIG. Predictably, returns and risks are something less than comparable in the two benchmarks. The Oppenheimer Real Asset A fund, which tracks the GSCI, had a standard deviation of 23.3 percent for the three years through January 2006, sharply higher than the 16.9 percent volatility rating for Pimco Real Return A fund, which mimics the DJ-AIG. As a result, the two funds can deliver sharply different performance results, at least in the short run. In 2005, for instance, the Oppenheimer fund's 26.4 percent total return was handily above Pimco's 19.9 percent.

If there's a lack of consensus for building a relevant commodities index, there's even wider disparity when it comes to analyzing raw materials with an eye toward figuring out an enlightened allocation.

"There are no book values, no yields," says Jeffrey Christian, managing director of CPM Group, a commodities research and consulting firm in New York. Financial analysis ? la stocks and bonds won't work here. Commodities, unlike equities or debt securities, don't have income streams, break-up values or some inherent or underlying net worth. That's not to say that CPM falls short when it comes to expending analytical effort. Indeed, the company publishes a wide range of fundamental analysis on such variables as supply and demand for a range of commodities. But translating the mountain of research published in the name of commodities research by CPM and others doesn't easily translate into strategic enlightenment when it comes to deciding on how to treat raw materials within an asset allocation framework.

The strange world of commodities persuades some to abandon fundamental analysis outright. In its review of commodities funds, Morningstar, for instance, doesn't evaluate the underlying markets for raw materials. "We're not taking a view of crude oil or natural gas or livestock or gold," says Karen Dolan, one of the Morningstar analysts who follow commodities funds. Rather, the focus is on monitoring expenses, the tax impact, how the funds' portfolio holdings differ from one another, and other big-picture issues, she says--in other words, the top-down approach that Morningstar has long favored in its fund analysis.

A number of financial advisors using commodities funds for clients tend to avoid the details on an individual commodity basis, too. Frank Armstrong, a CFP and president of Investors Solutions, uses Oppenheimer Real Asset for client portfolios, but says that he doesn't analyze markets per se, whether its commodities, stocks or bonds. "I analyze a client's risk tolerance and his need for liquidity over the next seven to 10 years. Nobody pays me to make market forecasts, and they shouldn't. We believe in a strategic long-term asset allocation that's tailored to a client's need for liquidity and risk tolerance."

Dan Pierce, a portfolio manager in State Street Global Advisors' global asset allocation group, recommends analyzing commodities on a relative basis. That includes looking at the performance of commodities relative to the global economy. By that measure, Pierce remains encouraged that commodities are still an attractive investment. "For, say, the 20 odd years through 2001 and 2002, the value of commodities was stagnant, while economies grew dramatically," he observes. Although commodity prices generally have been rising since 2002, he thinks they still have room to run, in part to correct for the sideways movement in the past while the global economy expanded, pushing up demand for raw materials in the process. In fact, comparing the value of oil produced each year to the world gross domestic economy appears to back up his point (see Chart 1).

Pierce also recommends looking at how commodity-related equity investments are valued by Wall Street. In the S&P 500 stock index, for example, the energy sector represented just under 10 percent of the benchmark's market capitalization, well below the roughly 30 percent in the previous bull market for oil in the early 1980s.

All of which may carry financial advisors a bit far afield from the familiar methodologies for crafting asset allocation strategies. But there's more familiar analytical terrain when it comes to commodities, opines Gibson Capital Management's Roger Gibson. Although the asset class has differences relative to stocks and bonds, it can be modeled like equities or bonds for devising a strategic plan and portfolio weight. The first step is calculating commodities' estimated returns, standard deviation, and correlations relative to stocks, bonds, cash, etc. With that data, computing an efficient frontier for a portfolio that incorporates raw materials is routine.

In fact, Gibson has done just that, and comes to the conclusion that commodities do, in fact, help diversify a portfolio by enhancing risk-adjusted returns. Throwing numbers into a portfolio optimizer software package is one thing, but is there a theoretical basis for thinking asset allocation can be improved with commodities? Absolutely, says Gibson, citing work done by famed British economist John Maynard Keynes, who pioneered the notion of "backwardation" in commodities in the 1930s.

According to Keynes, commodity futures generate positive returns over time. The reason: commodity producers, such as farmers, sell futures at a discount to the expected spot, or cash price on any given day. Investors buy the contracts and realize a profit as the futures prices rise over time toward spot. Why are sellers willing to sell futures at a discount? Because that's the price for transferring price risk to the buyer.

Keynes' backwardation theory is just a theory, concedes K. Geert Rouwenhorst, a finance professor at Yale School of Management. In fact, it's a theory that some reject. "We cannot 'prove' whether Keynes was right or not as we cannot observe expected spot prices," he notes. Nonetheless, his recent study of commodities futures from 1959 through 2004 finds empirical support for Keynes' theory. "Facts and Fantasies about Commodity Futures," which Rouwenhorst co-authored with Gary Gorton, a Wharton professor at the University of Pennsylvania, concludes that the risk premium on commodities futures is comparable to equities over time, and that commodities futures returns are negatively correlated with bonds and stocks.

Commodities may fit easily into asset allocation strategies after all. But even if you accept that raw materials can be modeled for strategic purposes, that still requires coming up with a forecast of expected returns. The task is equally difficult for commodities, stocks and bonds, or any other asset class for that matter. Indeed, the future isn't getting any clearer when it comes to divining the prospects for risk and reward, but at least there's an expanding list of tools for hedging the unknown.

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