The Role of Commodities
Physical commodities are either pulled out of the ground or grown on top of it. Each year there is more than $1 trillion in global production in these areas. Here are the five major commodity groups, with examples of each:
1. Energy: such as crude oil, unleaded gasoline, natural gas and heating oil.
2. Agricultural Products: such as wheat, corn, soybeans, cotton, sugar, and coffee.
3. Industrial Metals: such as aluminum, copper, nickel, and zinc.
4. Livestock: such as live cattle, and lean hogs.
5. Precious Metals: such as gold, and silver.
There are a variety of ways to invest in these commodities. You might think about owning them physically, but that's both expensive and impractical.
Another possibility would be to own shares of commodity producers. If you are interested in energy, for example, you could always choose to own oil-company stocks. The share prices of commoditity producers, however, do not behave like the underlying commodities because they are impacted by other market factors.
There are also actively managed commodity pools. These investments are generally expensive, returns are dependent on the manager's skill, and the results do not necessarily reflect the returns in the commodity markets.
A remaining alternative is index investing at an asset-class level. The Goldman Sachs Commodity Index (GSCI) and the Dow Jones AIG Commodity Index both provide continuous exposure to physical commodities through derivitives. The GSCI is a weighted index of global production in those five commodity groups. Seventy percent of the market value of those five groups is energy, so the GSCI is heavily tilted toward energy.
Whereas a more traditional portfolio strategy might focus on U.S. stocks, bonds, and cash, an alternate approach might be as follows: Change your focus to FOUR equity classes instead which includes U.S. stocks, non-U.S. stocks, real estate, and commodities. This can be thought of as a "big-picture approach" which is not dependent upon superior skill - either in selection of securities or market findings.
Commodities as an asset class, are a unique building block compared to other financial asset classes. Combining U.S. stocks, international stocks, real estate securities and commodities provides the highest return and the lowest standard deviation. You can win both by reducing risk and improving return.
If you look at combinations of two assets classes such as half U.S. stocks and half commodities, this would have the least risk and a higher return than any other combination, which is rather surprising. How did that happen? The answer has to do with correlation.
It is very important whether or not asset classes in a portfolio tend to move up and down together. All other things being equal, a negatively correlated asset is a more powerful thing to include in a portfolio than a positively correlated asset. You can reduce volatility by adding an asset class that tends to move in a countercyclical pattern compared to the other components of the portfolio. And when you reduce the volatility, the rate at which money compounds tends to go up.
While commodities tend to be countercyclical to the other asset classes and for that reason reduce risk in a portfolio, it doesn't always work that way. From 1980 to 1985, for instance, U.S. stocks and commodities moved up and down together.
The return implication of the countercyclical nature of commodities shows the growth of a dollar in the U.S. stock market versus that of commodities from 1971 to 2005.
A dollar invested in the S&P 500 Index (with full reinvestment of income) grew to $37.25 over those years. Meanwhile, a dollar in commodities alone with full reinvestment over the same time period grew to $47.56. But when you split that dollar between the two asset classes and annually rebalanced back to the 50-50 allocation, the investment grew to be worth $62.51, considerably ahead of either component.
Correlation between the four asset classes can also help explain whether or not these kinds of payoffs can continue. With all other things equal from a portfolio construction point of view, negative correlation is a good thing. Average correlation between U.S. stocks, international stocks and real-estate securities were all positive between 1972 and 2005. Commodities, on the other hand, had a negative correlation to each of those asset classes.
There isn't any reason to believe over a multiple-decade time period that any one of these asset classes will necessarily do any better than any other. In fact, their growth paths would tend to converge.
The beauty of this, however, is they are like different cylinders firing in a car. You don't want your cylinders to all fire at the same time, or your engine would explode. You are much better off having your cylinders taking turns firing, and this is exactly what these asset classes tend to do.
Because they have dissimilar patterns of return, if you are patient and continue to own the underperforming asset class, it tends to eventually take its turn in the sunshine again. By having payoffs at different periods of time, you smooth out your returns and create a better overall rate of return. You tend to win both in terms of risk reduction and return enhancement.
* * * * *
1. Energy: such as crude oil, unleaded gasoline, natural gas and heating oil.
2. Agricultural Products: such as wheat, corn, soybeans, cotton, sugar, and coffee.
3. Industrial Metals: such as aluminum, copper, nickel, and zinc.
4. Livestock: such as live cattle, and lean hogs.
5. Precious Metals: such as gold, and silver.
There are a variety of ways to invest in these commodities. You might think about owning them physically, but that's both expensive and impractical.
Another possibility would be to own shares of commodity producers. If you are interested in energy, for example, you could always choose to own oil-company stocks. The share prices of commoditity producers, however, do not behave like the underlying commodities because they are impacted by other market factors.
There are also actively managed commodity pools. These investments are generally expensive, returns are dependent on the manager's skill, and the results do not necessarily reflect the returns in the commodity markets.
A remaining alternative is index investing at an asset-class level. The Goldman Sachs Commodity Index (GSCI) and the Dow Jones AIG Commodity Index both provide continuous exposure to physical commodities through derivitives. The GSCI is a weighted index of global production in those five commodity groups. Seventy percent of the market value of those five groups is energy, so the GSCI is heavily tilted toward energy.
Whereas a more traditional portfolio strategy might focus on U.S. stocks, bonds, and cash, an alternate approach might be as follows: Change your focus to FOUR equity classes instead which includes U.S. stocks, non-U.S. stocks, real estate, and commodities. This can be thought of as a "big-picture approach" which is not dependent upon superior skill - either in selection of securities or market findings.
Commodities as an asset class, are a unique building block compared to other financial asset classes. Combining U.S. stocks, international stocks, real estate securities and commodities provides the highest return and the lowest standard deviation. You can win both by reducing risk and improving return.
If you look at combinations of two assets classes such as half U.S. stocks and half commodities, this would have the least risk and a higher return than any other combination, which is rather surprising. How did that happen? The answer has to do with correlation.
It is very important whether or not asset classes in a portfolio tend to move up and down together. All other things being equal, a negatively correlated asset is a more powerful thing to include in a portfolio than a positively correlated asset. You can reduce volatility by adding an asset class that tends to move in a countercyclical pattern compared to the other components of the portfolio. And when you reduce the volatility, the rate at which money compounds tends to go up.
While commodities tend to be countercyclical to the other asset classes and for that reason reduce risk in a portfolio, it doesn't always work that way. From 1980 to 1985, for instance, U.S. stocks and commodities moved up and down together.
The return implication of the countercyclical nature of commodities shows the growth of a dollar in the U.S. stock market versus that of commodities from 1971 to 2005.
A dollar invested in the S&P 500 Index (with full reinvestment of income) grew to $37.25 over those years. Meanwhile, a dollar in commodities alone with full reinvestment over the same time period grew to $47.56. But when you split that dollar between the two asset classes and annually rebalanced back to the 50-50 allocation, the investment grew to be worth $62.51, considerably ahead of either component.
Correlation between the four asset classes can also help explain whether or not these kinds of payoffs can continue. With all other things equal from a portfolio construction point of view, negative correlation is a good thing. Average correlation between U.S. stocks, international stocks and real-estate securities were all positive between 1972 and 2005. Commodities, on the other hand, had a negative correlation to each of those asset classes.
There isn't any reason to believe over a multiple-decade time period that any one of these asset classes will necessarily do any better than any other. In fact, their growth paths would tend to converge.
The beauty of this, however, is they are like different cylinders firing in a car. You don't want your cylinders to all fire at the same time, or your engine would explode. You are much better off having your cylinders taking turns firing, and this is exactly what these asset classes tend to do.
Because they have dissimilar patterns of return, if you are patient and continue to own the underperforming asset class, it tends to eventually take its turn in the sunshine again. By having payoffs at different periods of time, you smooth out your returns and create a better overall rate of return. You tend to win both in terms of risk reduction and return enhancement.
* * * * *
posted by Bob Moser at
2:11 PM
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