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Don’t Forget Commodities When Diversifying

By: Robert Gordon

By: Robert J. Gordon, MBA, CFP®, AIF®

By now, most investors are familiar with the importance of diversification when constructing their portfolios. Investment management firms, brokerages, annuity salesman and others happily extol the virtues of diversification to clients. Very rarely are they talking about creating portfolios of non-correlated assets – the type of portfolio that delivers the benefits championed by Modern Portfolio Theory (“MPT”). Commodities are an important component in creating truly diversified portfolios.

Modern Portfolio Theory tells us that combining non-correlated assets in a portfolio reduces the overall risk of the portfolio at every level of return. The measure of risk in this context is typically standard deviation. The advent of highly liquid, easily accessible investment vehicles like ETFs and index mutual funds, both tracking popular commodity indices, has made it easy for the average investor to get access to this complex asset class. The most popular index tracking this asset class is the Goldman Sachs Commodity Index (“S&P GSCI”) which tracks a range of important commodity contracts (a total of 24) including energy, industrial metals, precious metals, agricultural products and livestock. It is a production-weighted index meaning that the allocation of the various commodities within the index is driven by the dollar value of their production around the globe. The index currently weights energy at approximately 78% of the index’s value.1

Over the last 12 months, the S&P GSCI significantly outperformed other major domestic and international indices. The tendency of commodities to move contrary to the general equity markets is reflected in the correlation statistics between major asset classes. The chart below shows the relative correlation between several key asset classes from January 1979 through June 2008.

S&P 500 Russel 2000 S&P GSCI
S&P 500 (Large Cap) 1.0000
Russell 2000 (Small Cap) 0.8046 1.0000
S&P GSCI (Commodities) -0.0373 0.0790 1.0000
Lehman US Aggregate (Bonds) 0.2409 0.1272 -0.0352

The correlation between the S&P 500 and the S&P GSCI is even less than the correlation of the S&P 500 to the Lehman US Aggregate suggesting that commodities are an excellent tool for diversification in a portfolio which includes equities and fixed income.

Low correlation with the equity markets is only a part of the story; commodities also exhibit a positive return history and positive expected returns to justify inclusion in a portfolio. By way of comparison, the table below shows returns and standard deviations for three important asset classes.

Performance Table January 1979 – June 2008
Portfolio Performance
Annualized Return (%) STD Dev (%)
S&P 500 (U.S. Large Cap) 12.5 14.8
S&P GSCI (Commoditites) 10.8 17.9
Russell 2000 (U.S. Small Cap) 12.2 19.1

Commodities have exhibited robust returns over a long period of time and with a level of risk which is in line with equities. The returns generated by commodities, as an asset class, clearly exceed inflation. The additional return (over and above the rate of inflation,) is generally considered to be a risk premium related to the relationship of expected future commodities prices relative to current commodity price levels. Of course, this pricing differential is related to the expected changes in the supply/demand characteristics of the underlying resources.2

What’s Next?

Is it reasonable to expect commodities to continue the torrid rise of the past five years? I don’t think so. When will it stop? Nobody really knows: however, the laws of economics might suggest that at some point, particularly in the case of energy, we might see consumers take action to curtail consumption which should cause demand to decrease or at least level out. Speculators have become the target of many politicians. The U.S. Commodity Futures Trading Commission (“CFTC”) has announced a number of initiatives to increase the transparency of the futures markets especially energy in an effort to curtail speculation.3 This is a good thing as long as it doesn’t affect liquidity – the ability of market participants to find willing buyers and sellers rapidly and with a minimum of costs.