Commodities are a very big deal now, thanks to oil prices, Katrina, and other
supply vicissitudes. But from an asset allo- cation point of view, does it make.
ADVISOR’S EDGE REPORT SEPTEMBER 2005 23
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Hot Commodities It’s not just oil and gas, but metals too A LT A S S E T S BY PIERRE SAINT-LAURENT
Commodities are a very big deal now, thanks to oil prices, Katrina, and other supply vicissitudes. But from an asset allocation point of view, does it make sense to have commodities in one’s portfolio? The answer rests upon the usual three parameters: returns, risk and correlations. Let’s look at the question from the point of view of passive commodities investing, namely, index investing. Several commodities indices are now investable and so constitute a viable approach to passive investing. The major indices are the Goldman Sachs Commodity Index (GSCI), the Standard & Poors Commodity Index (S&PCI), the Dow Jones-AIG Commodity
Index (DJ-AIGCI) and the Jefferies Commodity Performance Index (JCPI). Let’s consider how these commodities indices compare to other asset classes, as represented by a hedge fund composite index, the S&P 500 and MSCI World equity indices, as well as the Lehman U.S. Government/Corporate and Global Bond indices. Returns: One could argue that the returns for all commodity indices, save the JCPI, are lower, sometimes significantly, than both bond and stock indices over the 1990 to 2004 period. Clearly, the assessment needs to be completed by looking at the risk side of things. Volatility: Are lower commodity index returns due to lower volatility? Hardly, it seems. In all cases, volatility levels are close to or higher than equity, bond, or hedge fund index volatility levels.
There does not seem to be a clear return-risk advantage, then, for commodities in the portfolio. Correlation: Finally some good news. Correlation levels between commodity indices and other indices are remarkably low, sometimes negative. For example, the correlation coefficient between the GSCI and the S&P 500 is 0.08; between the S&PCI and the Lehman Government/Corporate bond index, it is 0.03. As a result, commodities have the potential for portfolio diversification. Very low correlations actually hint at one of the main attractions of commodity investing: its role as an inflation hedge. By now we’ve all forgotten about inflation, and for good reason, since it is defying the odds by remaining subdued. But remember that inflation means price increases. The most likely sources of future inflation will likely come from basic materi-
als and – you guessed it – energy. Commodity indices actually hold the potential of being long the items that will drive future price appreciation. Recent research tends to indicate the validity of this view. For instance, in Facts and Fantasies about Commodity Futures (2004), Gary Gorton and Geert Rouwenhorst develop a commodity futures returns index that covers the years 1959 to 2004. Their findings tend to show that commodities command a risk premium similar to those of equities, with negative correlations to equity and bond returns, due essentially to business cycle behaviour different from that of traditional asset classes. More importantly, they find that commodity futures are positively correlated with inflation, unexpected inflation (which is harder to hedge against), and changes in expected inflation. This view is corroborated by research done at Center for International Securities and Derivative Markets by Thomas Schneeweis and Richard Spurgin as well as other CISDM researchers.
The matter of expected (and unexpected) price increases seems all the more relevant given that raw materials in general have shown steep price moves – not just energy. According to Steve Poloz of Export Development Canada, non-energy commodities are hitting record price levels as well. It seems that commodities do have some attractive strategic, topdown, portfolio-building properties. The tactical question today is whether commodities as an asset class are likely to maintain steady price appreciation and drive general price levels higher, or whether slower worldwide economic growth and supply increases will mitigate price pressures on basic economic goods. A good strategist would build the portfolio for the long term, “beyond the economic cycle,” whereas the tactician will espouse Keynes’ famous saying that “in the long run, we are all dead.” Your pick. AER Pierre Saint-Laurent, M.Sc., CFA, CAIA, is president of AssetCounsel Inc. He can be reached at
[email protected].
COMMODITY INDEX PERFORMANCE 1990-2004
GSCI
Annualized Returns
S&PCI
DJ-AIGCI
JCPI
Hedge Fund Composite
S&P 500
Lehman Gov’t/Corp
MSCI World
Lehman Bond Global
7.08%
4.78%
6.89%
14.41%
13.46%
10.94%
7.77%
7.08%
8.08%
19.26%
12.85%
11.85%
15.46%
5.71%
14.65%
4.46%
14.62%
5.23%
0.15
0.04
0.22
0.65
1.61
0.45
0.78
0.19
0.72
-14.41%
-8.97%
-7.54%
-9.72%
-6.92%
-14.46%
-4.19%
-13.32%
-3.66%
Correlation GSCI
1.00
0.84
0.89
0.95
0.09
(0.08)
0.03
(0.06)
0.06
Correlation S&PCI
0.84
1.00
0.91
0.88
0.13
0.03
0.02
0.05
0.07
Correlation DJ AIG CI
0.89
0.91
1.00
0.94
0.19
0.08
0.03
0.15
0.12
Correlation JCPI
0.95
0.88
0.94
1.00
0.21
0.09
0.05
0.14
0.14
Annualized Standard Deviation Sharpe Ratio Minimum Monthly Return
Source: Center for International Securities and Derivatives Markets (CISDM), The Benefits of Commodity Investment - 2005 Update. Underlying data in USD.
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ANNOUNCEMENT
Inflation-Adjusted Performance
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2,000 1750 1500
Percent
1250 1000 Commodities Futures
750
Stocks 500 Bonds 250
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0 1959
1963
1967
1971
1975
1979
1983
1987
1991
1995
1999
2003
Source: Gorton and Rouwenhorst, Facts and Fantasies About Commodity Futures, 2004
