February 1, 2010

Commodities Help Diversify Portfolios

Presently, a debate centers on whether interest in commodities is again approaching bubble status, or is justifiable in recognition of the asset class's long-term fundamentals. As a research firm tasked with aiding client companies in making prudent strategic asset allocation and manager selection decisions, Prima Capital focuses on the latter--the long-term merits of adding commodity exposure to a traditionally well diversified portfolio. Therefore, from our view, wealth managers should focus their attention on three important aspects of the portfolio decision: i.) the long-term return potential of the asset class; ii.) the downside risk that must be accepted in order to realize those returns; and iii.) the diversification benefits that may be derived from imperfect correlations with other asset classes.

According to a paper published in 2004, "Facts and Fantasies about Commodity Futures, " by Gary Gorton of the University of Pennsylvania, and K. Geert Rouwenhorst of Yale University, the historical annual risk premium earned by investors in commodity futures contracts has been about 5%. The authors also found that the average annualized return for a fully collateralized (i.e. unlevered) investment in an equally-weighted index of commodity futures, using data going back to 1959, was comparable to the S&P 500 (10.8% vs. 10.5% as of the writing of their paper). Their findings were further supported by a study commissioned in 2006 by PIMCO and conducted by Ibbotson Associates, covering the years from 1970 to 2004. Ibbotson found that the composite commodity index used in the study produced the highest historical return among the asset classes considered, which included Treasury bills, TIPS, U.S. bonds, international bonds, U.S. stocks and international stocks.

However, if we look at the return history for the Dow Jones-UBS Commodity Index, which dates back to 1991, we find that commodities have underperformed both U.S. stocks and bonds through November 2009, while outperforming international stocks. Clearly these results are not as flattering as the longer term studies mentioned above would lead the reader to believe. However, both wealth managers and investors should note the interest rate environment against which bonds, in particular, have performed. Interest rates have been declining in both nominal, and more importantly, real terms, since 1981. That decline in rates has been a major tailwind for all assets, but particularly for bonds. With very little room on the downside, rates are likely to move sideways or upward in the coming years, changing from a tailwind to a headwind for fixed income securities.

A note on volatility

Thus, all things considered, we believe that the return potential of commodities has been sufficient to warrant inclusion in a diversified portfolio. Note, however, that this return potential does come at a cost: the volatility of an equally-weighted commodity futures index has been similar to that of the S&P 500, according to the Gorton and Rouwenhorst study. With large declines from time to time, investors and financial advisors alike should assume that commodities will continue to exhibit equity-like risk in the years ahead.

The final consideration in determining the proper role for commodities in a diversified portfolio is the correlation between commodity returns and those of stocks and bonds. Gorton and Rouwenhorst also found that over all horizons--except monthly--the correlation between equally-weighted commodity futures and stock and bond returns was negative, and that the negative correlation increased with time. Ibbotson also found that commodities have had a very low average correlation to other asset classes and a positive correlation to inflation, thus offering substantial diversification benefits. Our own research into this subject confirms that commodities provide meaningful diversification to a portfolio even during turbulent markets and after acknowledging that correlations to equities have likely risen to a new range in part as a result of the growth in emerging markets.

Thus wealth managers can conclude that a diversified basket of commodities offers attractive risk/return and portfolio diversification benefits for their clients' portfolios. We do not believe that investing in individual commodities will offer the same portfolio level benefits as will a broad-based basket of commodities. Further, exposure to the equities of commodity producers will likely not provide the same efficiency gains as will pure exposure to the asset class. By exposing client portfolios to a basket of commodities, preferably by dollar-cost-averaging into select mutual funds and/or ETFs to mitigate valuation concerns, wealth managers should improve the risk/return characteristics of their traditional stock and bond portfolios.

J. Gibson Watson III is president and CEO of Denver-based Prima Capital (www.primacapital.com), which conducts objective research and due diligence on SMAs, mutual funds, ETFs and alternatives.

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