The inclusion of commodities or managed futures as part of an overall portfolio has the ability to provide significant diversification, which can help shield your investment from extreme market conditions.
A study by Professor Craig Israelsen at BYU provides information about diversification using commodities.
Futures and options are not suitable for all investors. However, Professor Israelsen's report, "The Benefits of Low Correlation", indicate that an investment in commodities, often notionally considered too risky for the individual investor, could be beneficial under the right circumstances.
These are only the opinions of Professor Craig Israelsen and the original report is available at Index Universe. The interview with Professor Israelsen is available at the HAI (Hard Assets Investor) website:
* The Benefits of Low Correlation - Index Universe
* Craig Israelsen's Seven Asset Portfolio - HAI
From the interview with Prof. Israelsen:
HardAssetsInvestor.com [HAI]: What drove you to create this "quasi-commodities" portfolio, as you call it?
Craig Israelsen (Israelsen): What motivated me to look at this was that these commodity funds use complex strategies, and complexity is not always a virtue. Complex strategies cost money and can melt down upon implementation. These funds use derivatives and structured notes, and they're simply not as straight-forward as traditional mutual funds.
The Rogers commodity fund was even frozen for a while following the Refco bankruptcy. You don't see an S&P 500 equity fund having its assets frozen. Oppenheimer's commodities fund also had logistical problems last year.
Goldman Sachs has been calculating the GSCI since 1970. You have to ask yourself: why haven't there been products mimicking it until recently? If it's a good idea, why didn't they do it a while ago? The answer is that it's hard to implement, and to get it into a product that's not too expensive. What's changed about our markets to make that possible today? Are our markets that much more advanced? I don't know, but it's enough of a question in my mind that investigating an alternative seemed like it was worth doing.
HAI: What exactly did you find in the study?
Israelsen: When you look at the GSCI, as of June (2007), it was about 70 percent in energy. So, instead of investing that money in a commodities fund, you could take your money and invest it in an energy sector fund.
And between industrial metals and precious metals, that's about 14 percent of the S&P GSCI. So you can take that money and invest it in a precious metals equity fund. And now you are up over 80 percent of exposure.
And you also could consider real estate equities as another "alternative" asset.
You know that stocks and the futures are going to perform differently, but you also know that the equity funds will have some advantages. For instance, you may gain some cost savings through expenses that tend to be lower in well-established sector funds. Commodities funds are typically not the cheapest funds around, with expense ratios in the 75-240 basis point range. Stock funds are usually much cheaper.
HAI: And did it work? Did you get similar performance?
Israelsen: The primary thing you obtain in commodities is very low correlation to equities - basically, you want the commodities to act as a cushion in the portfolio during difficult times. Generally, I found that incorporating these sector fund-based alternatives (energy, metals, and real estate) into aggressive portfolios boosted returns and lowered the worst one-year drawdowns compared to the same aggressive portfolios with a similar allocation to commodities. In safer, retirement-style portfolios, the three "quasi-commodity" sector fund approach increased the risk somewhat. But overall, the three quasi-commodity sector funds filled a similar service as commodities themselves.
The advantage of using sector funds, beyond the points I outlined above, is that you have the ability to finesse the focus of your "commodity-like" exposure. In other words, rather than a 70% allocation to energy which the GSCI has, you might equally weight energy, metals, and real estate when using sector funds. This suggests that an investor is actively managing their passive assets, but the sector approach does make it possible.
HAI: There is certainly a lot of discussion about the different allocations between different commodity indexes.
Israelsen: Right, and with the sector equity funds, you can fine tune that. The truth is, commodities funds are often gauged after indexes, but can we honestly say that the GSCI is a passively managed index? No, I don't think so. I would argue that a commodities index is a fairly actively managed index, and even if an investor chooses to invest in a commodities fund that tracks an index, well, they're still going to have to live with the fact that the index is being actively managed in a sense, and they might prefer different exposure. If you've already admitted that your commodities fund is active, then you should ask, how actively do I want to manage that part of my portfolio. Do I want more control at the individual asset level?
HAI: How much exposure should an investor have to commodities and alternative asset classes?
Israelsen: Both sector funds and commodities are like Tabasco sauce: they are meant to be a small ingredient in a larger recipe. In terms of actual numbers, a portfolio allocation of 10-15% in commodities or quasi-commodities is very helpful in smoothing the performance of the overall portfolio.
In a November/December 2007 article in the Journal of Indexes ("The Benefits Of Low Correlation"), Israelsen examined the performance of a simple portfolio built with combinations of up to seven different asset classes: large-cap U.S. equities, small-cap U.S. equities, non-U.S. equities, U.S. intermediate-term bonds, cash, REITs and commodities.
His conclusion? Only REITs and commodities added a major diversification benefit, and they deserve to be considered for inclusion in investment portfolios ... including conservative retirement portfolios.
This is a particularly difficult subject for many individuals who are managing investment portfolios while in retirement because most people either think that commodities don't provide enough returns or that they are too volatile.
The most interesting part of the report is shown in the chart below - not so much the combination of adding REITs and commodities (as noted above), but the effect of just adding commodities.
First you start with an equally weighted six assets investment portfolio consisting of the following:
1. Large-cap U.S. equities
2. Small-cap U.S. equities
3. Non-U.S. equities
4. U.S. intermediate-term bonds
5. Cash
6. REITs
And then you add in commodities in the form of the GSCI Commodities Index. Note how the overall rate of return goes up slightly, but, more importantly, the worst years are much less severe.
As the seven assets portfolio was constructed, there were no periods with cumulative losses of 10 percent or worse whereas for the six assets portfolio these losses occurred up to 5 percent of the time. For a "stocks only" portfolio, losses of 10 percent or worse happened up to 14 percent of the time, depending on the mix of stocks.
This is a subject that doesn't get near the attention that it should - after one, two, or three years of losses, a lot of individual investors bail on their investment approach, locking in those losses, as many did earlier in the decade.
More from Professor Israelsen:
Israelsen: "I've recently updated the data on this study. Between 1970 and 2006, large-cap U.S. equities had about an 11% return. But there were eight years in that 37-year period where large-cap stocks had a negative return. Moreover, the worst 3-year cumulative return was about 38%, from 2000-2002.
Over that same time period, commodities had an average annual return of 11.5%. They had nine years with a loss, so one more than large-cap U.S. stocks. But the worst 3-year return for commodities was only 26% - much better than equities."
The returns get even better if you favor the asset class(es) that happen to be in a secular bull market and reduce your exposure to the one(s) in a secular bear market.
You can see the secular bulls and bears in the chart below using data from the report.
The period from 1966 to 1982 is generally considered a commodity bull/stock bear market which was then followed by the opposite conditions from 1982 to 2000.
Since the turn of the century, despite what you may hear on CNBC, it's pretty clear that it has flipped back to commodity bull/stock bear.
What's striking in the chart above is how you can have a big up year or two during a bear market and a horrible year or two within a bull market. Also, the best six years of gains - 1973, 2000, 1972, 1999, 2007, 1974, 1989 - were all for commodities.
Unfortunately, by the time your typical retail investor embraces the whole idea of commodities as an important asset class - sometime in the next decade - the commodity bull market will probably be nearing its end.
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