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Commodities As An Asset Class

By: Frank Armstrong

By: Frank Armstrong, CFP, AIF

At first blush, commodities sounds like a risky strategy that only a wild and crazy guy would consider. In fact it’s just the opposite. Properly utilized, it’s a way to reduce risk in a portfolio consisting of stocks and bonds.

We are not talking about an individual contract in a single commodity. You have probably heard radio advertisements advocating heating oil contracts as a brilliant way to trade for obscene profits. It sounds nuts, and it is. We are not going there.

Just a little background: There was an active grain futures market in Amsterdam 100 years before Columbus sailed. Profits were very similar to what we see today. And profits are the name of the game. If participants didn’t expect and receive returns commensurate with the risk they accepted for supplying capital to markets, the markets would cease to exist.

I think buying one stock is crazy, self defeating, delusional behavior. But buying an index of stocks is entirely appropriate for long term investors. It’s the same in commodities. One option or one contract is a speculation and a risky behavior not likely to be rewarded in proportion to the risk assumed. But, it makes perfect sense to purchase a diversified portfolio spread out over the entire market. Investors get paid for supplying capital to markets.

Let’s turn our attention to the performance of the market as opposed to the individual issues. If we look at the long term performance of the commodities indexes, we see a return similar to stock returns with roughly similar risks. If you don’t think investing in small company stock indexes is crazy (for a small part of your equity portfolio), you shouldn’t be uncomfortable with commodities either.

What makes this so attractive to investors is the very low correlation to the traditional stock and bond asset classes. Commodities go their own way almost without regard to stocks and bonds. That means that when the traditional securities markets are in the tank, there is a good probability that your commodity account will be positive, mitigating or reducing the loss.

The trick is to buy the entire market as represented by a widely diversified index. Until recently that wasn’t possible. No funds existed that allowed individual investors to participate in the commodities markets without excessive risk. Those markets were the exclusive preserve of the speculators and traders.

Until just recently smaller investors were unable to participate in commodities in a convenient manner. But in March 1997, Oppenheimer created their Real Asset Fund, using bonds, Commodity Linked Notes, other hybrid instruments, and derivatives to replicate the performance of the GSCI. The fund’s managers can overweight or underweight portions of the index, and actively manage the bond portfolio to enhance returns. While we would prefer a totally passive approach, so far the fund has closely tracked the index. In our back testing, we found substantial benefit to performance whether we used the raw index returns or the actual live fund returns. As investment advisors we are able to buy it for our clients without a load in institutional class shares, making for effective and economical implementation.

This is not your average mutual fund. Commodities offer compelling potential advantages that cannot be duplicated by other financial assets. But they are so thoroughly different from what we usually encounter with stocks and bonds that some serious homework is in order before taking the plunge.

So, how do commodities work?

Farmer Fred And Baker Bob

Suppose you are a wheat farmer. One of your many concerns is that the price of wheat will drop just as you are harvesting. You could have a great crop, and still not be able to sell it for enough to cover your costs. Like it or not, you have what the futures market might call a long position in wheat. Fortunately, across town is a baker who is concerned that the price of wheat might go up. Because he uses wheat to make his bread, he needs to lock in what his wheat costs will be.

So, you sell your wheat to the baker now at a mutually agreed-upon price, for delivery when harvested. You have entered into a forward contract. In the more common situation, if you don’t know a baker who needs wheat, you can buy a futures contract on a commodities exchange to accomplish the same result. This is not an options contract; you will deliver the wheat at the time specified, or you must buy your way out of the contract at the then-current price.

So far, you haven’t done anything very risky. In fact, you have reduced the most serious risk facing your farm. As a farmer you already had a long position in wheat with a serious downside. By entering into the futures contract, you hedged away the risk of falling wheat prices. Of course, if the price of wheat goes up, you will not make as much profit. But, you will survive and profit to farm another day.

The baker, as a commodity consumer, had a short position in wheat, and was able to hedge away his risk of rising prices by buying a long contract.

As long as we have an equal number of hedgers on either side of the contract, we have a simple zero-sum game. If the price of wheat moves from the agreed price, whatever one side “loses” the other side gains.

But what if there are more farmers concerned about falling prices than bakers concerned about rising prices? How can we “clear the market” then? Someone must supply the capital to balance the trades.

Speculator Sue

What this market needs is speculators–someone to buy those long positions from the farmer. But why should a speculator risk capital by buying a commodity that she has no business reason to own? After all, she doesn’t really want the wheat, and if the price goes down, she’s out of luck. At the end of the contract, she owns the wheat, and must sell it at the current price (also known as the spot price). (She would normally close out her contract, and realize her profit or loss, before she was required to take delivery.)

The only way our speculator is going to be attracted to the market is if she can buy the wheat at a sufficient enough discount from the expected market price to provide her with a reasonable profit. So, if there is an imbalance between buyers and sellers, then futures prices must adjust enough to provide an attractive profit potential to speculators. And it goes without saying that the profit potential must be appropriate for the level of risk.

A Commoditized Index

How might such a portfolio have performed? The Goldman Sachs Commodity Index (GSCI) tracks a broad range of important commodity contracts including energy, industrial metals, precious metals, agricultural products, and livestock. (There are several other alternative indexes.) The index measures the total return that investors receive from an unleveraged, fully collateralized, passive, long-only position in the commodities. The GSCI is adjusted to account for commodity-market activity.

GSCI Components and Weights

Currently, 24 commodities meet the eligibility requirement for the GSCI. A list of these components and their dollar weights in the GSCI organized by sub sector.

Table 1: GSCI Components and Dollar Weights (%) (July 20, 2004)

Energy 70.31 Industrial Metals 7.29 Precious Metals 2.19 Agriculture 13.66 Livestock 6.56
Crude Oil 26.98 Aluminum 3.10 Gold 1.97 Wheat 3.13 Live Cattle 3.71
Brent Crude Oil 12.44 Copper 2.40 Silver 0.22 Red Wheat 1.38 Feeder Cattle 0.83
Unleaded Gas 8.74 Lead 0.32 Corn 3.36 Lean Hogs 2.01
Heated Oil 7.67 Nickel 0.93 Soybeans 2.19
Gas Oil 4.26 Zinc 0.50 Cotton 1.23
Natural Gas 10.22 Sugar 1.42
Coffee 0.65
Cocoa 0.29

There are three important elements of return: A collateralized contract will earn the risk-free return, plus the risk premium, plus (or minus) the change in spot prices. The long position will tend to move in the same direction with the price of the underlying commodity. After all, the contract may change hands many times, but it has a finite life. In the end, someone holds the product. Spot prices and futures prices must be the same on expiration day.

Although inflation has been low lately it is a lingering concern. Commodities along with real estate and stocks are an excellent inflation hedge. Additionally, you might argue that they provide a war and/or terrorism hedge. Commodity prices rise in times of uncertainty.

Returns and Volatility of the GSCI vs. Other Indexes


GSCI S&P 500 MSCI EAFE Microcaps L/T Govt 1mo T-Bill
Annual Return% 11.85 11.3 10.09 12.28 9.19 6.26
Growth of $1 45.08 38.06 26.25 51.31 19.89 7.89
Std Deviation 24.53 17.48 22.64 27.93 11.75 2.83

Long term data is very encouraging. The index offers an average return about equal to the S&P 500 but with somewhat higher risk. The big benefit, however, is that it marches to an entirely different economic drummer. While stocks and bonds both retreat during times of rising inflation, commodities surge ahead.

Correlations: Commodities and Other Asset Classes


GSCI S&P 500 MSCI EAFE L/T Govt 1mo T-bill Microcaps
GSCI 1 -0.271 -0.128 -01.98 -0.003 -0.382
S&P 500 -0.271 1 0.592 0.271 0.028 0.657
MSCI EAFE -0.128 0.592 1 0.078 -0.117 0.404
L/T Govt -0.198 0.271 0.078 1 0.017 0.047
1mo T-Bills -0.003 0.028 -0.117 0.017 1 -0.126
Microcaps -0.382 0.657 0.404 0.047 -0.126 1

For those of you who are visual, here’s the returns of the GSCI Commodities index vs. SP500 for the period 1970-2003. You can see there’s almost no relationship between the two.

As an asset class, commodities offer unique diversification benefits that show remarkably low correlation to almost all other financial assets. A small weighting in commodities may have the potential to significantly reduce risk in a diversified portfolio.