Index Oct-04 QTD YTD Description
S&P 500 Index* 1.40% 1.40% 1.64% Large-cap stocks
DJIA* -0.52% -0.52% -4.08% Large-cap stocks
Nasdaq Comp.* 4.12% 4.12% -1.42% Large-cap tech stocks
Russell 1000 Growth 1.56% 1.56% -1.11% Large-cap growth stocks
Russell 1000 Value 1.66% 1.66% 7.29% Large-cap value stocks
Russell 2000 Growth 2.43% 2.43% 1.74% Small-cap growth stocks
Russell 2000 Value 1.55% 1.55% 9.66% Small-cap value stocks
EAFE 3.42% 3.42% 8.20% Europe, Australasia & Far East Index
Lehman Aggregate 0.84% 0.84% 4.22% U.S. Government Bonds
Lehman High Yield 1.81% 1.81% 8.19% High Yield Corporate Bonds
Calyon Financial Barclay Index** 1.73% 1.73% -3.77% Managed Futures
3-month Treasury Bill 0.90%
All returns are estimates as of October 31, 2004. *Return numbers do not include dividends. **Returns as of October 28, 2004.

In an environment characterized by muted expectations for stock and bond returns, commodities have suddenly become the newest must-have investment. Research performed over the last twenty years has found that including commodities in a portfolio of stocks and bonds produces many advantages. The most recent treatise on the subject, Facts and Fantasies about Commodity Futures, by Gary Gorton of the Wharton School of Business and Geert Rouwenhorst of Yale, studied the characteristics of an equally weighted index of futures contracts between 1959-2004. They concluded that futures investments have returned roughly the same as equities over that time, but were negatively correlated to both stocks and bonds.

Changes in commodity prices, though, are just one of four sources of return for commodity indexes. According to Robert Greer, author of “The Nature of Commodity Returns” (The Journal of Alternative Investments, Summer 2000) and portfolio manager for the Pimco Real Return commodity mutual fund, there are three other ways such indexes can increase in value over time: T-bills, which are typically purchased as collateral for futures trading; the so-called risk premium that accrues to traders as a return for taking risk away from end users of commodities; and a rebalancing bonus, which is accrued by adding to and reducing positions back to targeted allocations.

There is little doubt that commodities are a rational component to a traditional portfolio. The real question is whether a passive, long-only strategy is more effective than a more active approach. Such a question is relatively easy to answer with equity and fixed income investments, since active managers who operate in those segments of the capital markets have return attributions that are quite similar to passive indexes.

In futures, that is not the case. Rather than being market-based, the returns of CTAs have been found to have a set of explanatory factors based on the advisor’s trading style (e.g., trend-based, discretionary, etc.) and the set of asset markets traded. In contrast, neither the general direction of commodity markets nor any set of technical trend-following rules is helpful in explaining managed futures returns. However, CTA indexes typically have higher risk-adjusted returns and lower drawdowns than commodity indexes.

Although they share some common attributes, long-only commodity indexes and managed futures are distinctly different investments, and the investors who choose one or the other frequently do so for unique reasons. Those looking to express their view that the global economy is expanding would choose a long-only commodity index, while those seeking to create the most efficient portfolio possible would be more attracted to the services of a trading advisor.

Ben Warwick is chief investment officer of

Sovereign Wealth Management in Denver and the author of Searching for Alpha: The Quest for Exceptional Investment Performance (Wiley, 2000) and The WorldlyInvestor Guide to Beating the Market (Wiley, 2001). You can purchase these books at the IA Bookstore at http://www.invest-store.com/investmentadvisor/.