DoCommoditiesBelonginYourAllocation?

ByGeoffConsidine
April8,2014
Formuchofthelastseveralyears,poorperformancefromcommoditieshashurtinvestorsportfolios,a
resultofdepressedinterestrates,lowinflationandsloweconomicgrowth.Anydiversificationvaluethey
providedwasmaskedbystrongequitymarketperformance.Myanalysisshowsthatonlyasmallallocation
tocommoditiesisjustified,andadvisorscanobtainmostofthesamebenefitswithrealestateinvestment
trusts(REITs)orindividualTreasuryinflationprotectedbonds(TIPS).

Illbeginwithareviewofthekeyresearchoncommoditiesasanassetclass,followedbyadiscussionofa
numberofrepresentativefundsthatprovidediversifiedexposuretocommodities.Inthefinalsection,Ill
presentMonteCarlosimulationsoftheportfolioimpactofaddingcommoditiesfundstoatraditionalstock
bondallocation.

Researchoncommoditiesasanassetclass

Themarketpriceofabasketofcommoditiesshouldincreaseroughlyinlinewithinflation,butwhywould
therebereturnsbeyondthis?Whilethespotpricesofcommoditiestendtotrackinflation,futures
contractsofcommoditieshavehistoricallydeliveredpositivereturns.

JohnMaynardKeyneslaidthefoundationofmodernthinkingoncommodityfuturesmarkets.Heproposed
thatinvestorsincommodityfuturesareprovidingriskcapacitytotheproducersofcommoditiesbyallowing
themtolockinafixedpriceforcommoditiestobedeliveredatafuturedate.Inotherwords,investorsin
futurecontractsareessentiallyinsuringcommodityproducersagainstadeclineinpricesinthefuture.

Investorscanbenefitfrompurchasingafuturescontractatadiscounttotheexpectedfuturespotprice.As
thedeliverydateapproaches,thefuturespriceshouldrisetomeetthespotprice.This,inturn,meansthat
theforwardcurve(thepricesoffuturescontractsasafunctionofdeliverydate)shouldfallasthetimeto
deliveryincreases.Thissituationisreferredtoasbackwardation.

Butwhatiffuturescontractsaremoreexpensivethanthespotpriceforacommodity?Asecondtheoretical
argumentpositsthatcommoditiesfuturespricesareexpectedtoincreasethroughtimetocreatean
incentiveforinvestorstobuildandmaintainstoragefacilities.Iflaterdatedcontractsaremoreexpensive
thanneartermcontracts,theshapeofthefuturescurveiscalledcontango.Storageaddsvaluefor
consumersofcommodities.Foragriculturalcommodities,productiontendstofollowaseasonalcyclebut
demandmaybeconstantyearround.Storageallowsproducerstoselltheircropswhentheyareharvested
andmaintainaconstantsupplyforconsumers.Forenergycommodities,productionmaybeconstantyear
round,butdemandmaybeseasonal.Priceswilladjusttomakeitworthwhileforinvestorstoprovide
stabilityofsupply.

-1 Copyright 2014, Advisor Perspectives, Inc. All rights reserved.

Inbothcases,thereisanexpectedpositivereturntoinvestorsbybeinglongcommodityfuturescontracts.
Thesetwobroadconceptsastowhylongonlycommodityinvestors,orinvestorswhoonlybetthat
commodityfuturespriceswilltendtoriseastheyapproachtheexpirationdate,shouldexpectpositive
returnsarereferredtoasthetheoryofbackwardationandthetheoryofstorage.

Theempiricalresearchdemonstratingthevalueofinvestingincommodityfuturesfocusesonfully
collateralizedfuturesstrategies.Buyingafuturescontractmeansthataninvestoragreestopurchasea
certainamountofacommodityataspecificpriceatthesettlementdate.Afullycollateralizedfutures
purchasemeansthattheinvestorconcurrentlybuysTreasurybillsinanamountequaltothepurchaseprice
ofthefuturescontract.Thismeansthatthereisnoriskthebuyerofthecontractwillbecaughtshortof
cashneededatthesettlementdate.

Historicalanalysisofcommodityfuturessuggeststhatinvestorshave,indeed,reapedattractiverisk
adjustedreturns.Inanowclassicpaperfrom2005,FactsandFantasiesaboutCommodityFutures,Gary
GortonandK.GeertRouwenhorst,bothoftheYaleSchoolofManagement,foundthatadiversifiedfully
collateralized(e.g.zeroleverage)basketofcommoditiesfutureshashistoricallyprovidedreturns
comparabletoequities.Inaddition,suchastrategyhasdeliveredreturnsthatarenegativelycorrelatedto
equities,whichmeansthatacombinationofequitiesandcommoditiesinaportfolioprovidedsubstantial
diversificationbenefits.

Thisanalysisuseddatafrom1959to2004.Anequalweightedannuallyrebalancedportfolioofcommodity
futuresprovidedreturnof11.2%peryear(arithmeticaveragereturnof11.97%peryear)inthis45year
period,withaverageinflationof4.1%peryear.Thespotpriceofabuyandholdportfolioofthesesame
commoditiesprovidedareturnthatwaseffectivelyequaltoinflation.Theauthorsconcludedthat
commoditiesfuturesprovidedaneffectivehedgeagainstinflationalongwithequitylikereturnsandthat
thebenefitsofafullycollateralizedcommodityfuturesstrategycannotbeachievedviainvestinginthe
equityofcommodityproducers.

AnotherimportantpieceofresearchoncommodityfuturesstrategiesisTheTacticalandStrategicValueof
CommodityFutures,byClaudeErbandCampbellHarveyofDukeUniversity.Thepaperconfirmedthata
diversifiedrebalancedportfolioofcommodityfutureshashistoricallygeneratedreturnscomparableto
equities,butwithsomeimportantcaveatsthatinvestorsneedtounderstand.Perhapsthemoststriking
findinginthispaperwasthatthecompoundedreturnforfuturesonindividualcommoditieswasnearzero.

Thissoundsparadoxical.Howcanaportfolioofzeroreturninvestmentshaveaveragereturnsofmorethan
10%peryear?Theanswerisinthediversificationreturn.Diversificationreducesthevolatilityofa
portfoliosreturnswithoutreducingthearithmeticaveragereturn.This,inturn,increasesthegeometric
returnoftheportfolio.Themagnitudeoftheincreaseinportfoliogeometricreturnisgreaterifthe
correlationsbetweentheportfoliocomponentsarelow.Thecorrelationsbetweencommoditieswereso
lowbetween1945and2004thatthediversificationpremiumwasenormous.

A2006paperbyIbbotsonAssociatesremainsoneofthebestoverviewsoftheportfolioimpactsofadding
commoditiestotheassetallocationmix.Thefocusofthisanalysiswasoncreatingestimatesofexpected
returnsfromadiversifiedcommodityfuturesportfolio,alongwithcorrelationstoothermajorassetclasses.
-2 Copyright 2014, Advisor Perspectives, Inc. All rights reserved.

Theanalysisincludedestimatesofexpectedreturnandriskforothermajorassetclasses.Usingthese
inputs,theauthorsthencalculatedoptimizedassetallocationportfolioswithandwithoutcommodities.
TheassetclassesincludedwereTBills,TIPS,U.S.bonds,internationalbonds,U.S.stocks,international
stocksandcommodities.Theoptimalmoderateriskportfoliointheirresultshada10%expectedvolatility
anda25%allocationtocommodities.Thisportfoliowasprojectedtoprovide0.65%peryearinadditional
returnascomparedtoanoptimalportfolioatthissamerisklevelwithoutcommodities.

Theresearchsuggeststhatdiversifiedcommodityfutureshavehistoricallyprovidedattractiveriskadjusted
returns,althoughtheIbbotsonstudysuggeststhatasubstantialallocationmaybenecessarytoexploit
thesebenefitsaspartofanoverallassetallocationplan.

Thelargestproblemwithanycommoditystrategyisthattheexpectedreturnsaredifficulttoestimate.In
recentyears,returnsfromcommodityfundshavebeenpoor.Rouwenhorstrecentlyarguedthatthelonger
termexpectedreturnsfromawelldesignedcollateralizedfuturesstrategyremainsubstantial,whileGMOs
JamesMontierarguedthatanincreaseinthespeculativelonginterestinthesemarkets(asopposedto
actualbuyersandsellersofcommodities)havesubstantiallyreducedtheexpectedreturnwhenfutures
curvesareinbackwardation.Anumberofcommoditieshavebeenincontangoinrecentyears,soinvestors
whowerelongfuturescontractsfoundthemselvessellingexpiringcontractsandbuyingmoreexpensive
longerdatedcontracts.ThisresultedinlossesratherthanthepositivereturnsthatKeyneshypothesizedfor
properlyfunctioning(i.e.,inbackwardation)futuresmarkets.

Montierisconcernedthatthissituationmaypersistduetoanabundanceofspeculators.Advisorswillneed
toassessofwhetherspeculatorswillcontinuetodrivemarketsintocontangoanderodeinvestorreturns.

Commodityfunds

Acommodityexchangetradedfund(ETF),exchangetradednote(ETN)ormutualfundprovidesthebest
accesstoadiversifiedportfolioofcommodityfutures.Iamgoingtodiscusswhatdistinguishesfourofthe
betterknownfunds.

Sampleofavailablecommodityfunds
Name

Ticker

Assets

iPathDowJonesUBSCommodityIndex DJP $1.7Billion

PowerSharesDBCommodityIndex
DBC $5.8Billion
PimcoCommodityRealReturn
PCRDX $14Billion
CreditSuisseCommodityReturn
CRSAX $5.6Billion

Expense
Ratio
0.75%
0.85%
1.19%
1.09%

FundType

Description

ETN
ETF
MutualFund
MutualFund

Fullycollateralizedfuturesindex
Fullycollateralizedfuturesindexwithrollstrategy
Activelymanaged
Activelymanaged

TheiPathDowJonesUBSCommodityETN(DJP)providesthesimplestandcheapestaccesstocommodity
markets.ThisETNisasimpleindextrackerthatpurchasesfuturescontractsof19majorcommodities,sells
thecontractsastheynearexpirationandpurchasescontractsinthenextmonth.Thistypeofsocalled
frontmonthrollstrategyisstraightforwardandshould,overtime,deliverapositivereturnwhenthe
futuresarebackwardationthepriceofthefuturescontractbeingsoldishigherthanthecontract
purchased.
-3 Copyright 2014, Advisor Perspectives, Inc. All rights reserved.


Sometimes,however,thefuturescontractswithlaterdeliverydatesaremoreexpensive,orincontango).
Thissituationcanresultinasubstantiallossforafrontmonthrollstrategyovertime.

ThePowersharesDBCommodityETF(DBC)providesapartialsolutiontotheproblemofcontangoroll
lossesbyrollingintolaterdatedcontractsratherthanthefrontmonth,toavoidcontangosituations.Over
thepastfiveyears,DBChasoutperformedDJPby2%peryear.Thishasbeenaperiodwhensomeenergy
commoditieshavebeenincontango.TheassetsinDBCaremuchgreaterthaninDJP,reflectingwidespread
acceptanceoftheapproach.

Beyondthetwoindextrackers,thereareanumberofactivelymanagedcommodityfuturesfunds.The
PIMCOCommodityRealReturnFund(PCRDX)andtheCreditSuisseCommodityReturnFund(CRSAX)are
thetwolargest.

Performanceofcommodityfunds(Source:Morningstar)
AnnualizedReturn(%)
5YearAnnualized
Name
Ticker
1Year
3Year 5Year
Volatility(%)
iPathDowJonesUBSCommodityIndex DJP
3.3
7.1
4.4
17.0
PowerSharesDBCommodityIndex
DBC
4.8
4.2
6.4
17.9
PimcoCommodityRealReturn
PCRDX
7.6
4.8
10.8
18.2
CreditSuisseCommodityReturn
CRSAX
3.4
6.8
4.7
15.8

Whilethereisconsiderablevariabilityintheperformanceofthesefunds,returnshavebeennegativefor
themostrecentoneandthreeyearperiods.Whiledevelopedmarketequitieshavereboundedsharply
overthisperiod,reducedexpectationsforgrowthinthedevelopingeconomies(particularlyChina)and
fallinginflationexpectationshaveresultedinbroadlydecliningcommoditiesprices.Commoditieshavealso
hadalowcorrelationtoequitiesandtobonds.Forthisreason,commoditiesarenotexpectedtoperform
wellwhenequitiesarerallying.

Correlationsofcommodityfundreturnstoeachotherandtomajorassetclasses(5years)
DJP
DBC
PCRDX
CRSAX
TIP
DJP
100%
DBC
94%
100%
PCRDX
97%
92%
100%
CRSAX
99%
95%
97%
100%
TIP(iSharesTIPSETF)
16%
15%
36%
17%
100%
S&P500
5%
13%
12%
5%
73%
AggregateBondIndex
63%
65%
65%
64%
1%
30YearTreasuryYield
29%
35%
16%
29%
66%
10YearTreasuryYield
42%
48%
33%
42%
47%
-4 Copyright 2014, Advisor Perspectives, Inc. All rights reserved.


Thoselowcorrelationsareevidentinthetableabove.Allofthefundshavepositivecorrelationstochanges
in30and10yearTreasurybondyields.Thecorrelationisfarfrom100%,however,sothereareclearly
otherfactorsthatexplaincommodityreturns.

ThecorrelationsalsodemonstratewhycommoditiesaresuperiortoTIPSasaninflationhedge.While
incomefromTIPSriseswithinflation,theirpriceshaveanegativecorrelationtoTreasurybondyields,as
shownbythenegativecorrelationbetweenTreasurybondyieldandthereturnfromTIPS(iSharesTIPS
ETF).TIPSperformbetterthantraditionalTreasurybondswhenyieldsincrease,buttheystilllosevalue.
BecauseTreasurybondyieldsriseinresponsetoinflation,commoditiesaremoreeffectiveasaninflation
hedgethanTIPS.

ThisresultappliestoTIPSfunds.AsingleTIPSbondprovidesaperfecthedgeforinflationoveritslifetime,
butthemarketvalueofthatbondmayvaryconsiderably.Totheextentthattheprimarygoalistohavea
constantvalueofpurchasingpowerataspecificfuturedate(thematurityofthebonds),aTIPSbondisthe
perfecthedge.Commoditiesfuturesprovidenosuchguarantee,buthavehistoricallyprovideda
substantiallyhigherreturnthaninflationaswell.

Assetallocationandcommodityexposure

Thefinalquestionishowmuchbenefitcommoditiesprovideandhowtochoosefromtheavailablefunds.
Toaddressthesequestions,IhaveusedQuantextPortfolioPlanner(QPP),aportfolioplanningtoolthatI
designed,tocalculatetheexpectedfutureriskandreturnassociatedwithabasicstockbondasset
allocationwithandwithoutcommodityfunds.QPPgeneratesforwardlookingestimatesofriskandreturn
forthecommodityfundsandotherassetclassesusingMonteCarlosimulation.

Istartedbycalculatingtheexpectedriskandreturnforaportfolioallocated60%toanS&P500fund(SPY)
and40%toanaggregatebondfund(AGG).Ithenrananoptimizertodeterminetheassetallocation
betweenSPY,AGGandoneormorecommodityfundsthatprovidedthehighestexpectedreturnforthe
samerisklevelasthe60/40portfolio.IusedthebaselinesettingsinQPP,inwhichtheS&P500has
expectedarithmeticnominalreturnof8.3%peryearwithavolatilityof15.1%.Asidefromthissetting,all
otherassetclassreturnsandrisklevelsaregeneratedbyQPP,basedonfiveyearsofhistoricaldata,
throughFebruary2014.

TheexpectedreturnofAGGfromQPPis2.4%(closetoitstrailing12monthyieldof2.3%),andthefour
commodityfundshaveexpectedtotalreturnsrangingfrom9%to10.3%peryear.Thesereturnsare
somewhatlowerthanthe11.97%arithmeticannualaveragereturnreportedbyGortonandRouwenhorst.

-5 Copyright 2014, Advisor Perspectives, Inc. All rights reserved.

Projectedreturnandvolatilityforcommodityfunds
Beta With Respect to
S&P500
DJP
0.74
DBC
0.81
PCRDX
0.82
CRSAX
0.71
SPY
1.00
AGG
-0.04
Ticker

Expected
Volatility
17.9%
18.8%
19.2%
16.6%
15.1%
3.2%

Expected
Return
9.7%
10.2%
10.3%
9.0%
8.3%
2.4%

A60/40portfoliohasexpectedreturnof5.93%peryearandexpectedvolatilityof9.0%peryear.Iusedan
optimizertodeterminetheoptimalallocationofeachcommodityfundthatwouldincreaseexpectedreturn
withoutincreasingrisk.Ihavealsosimulatedcasesthatincludedtwocommodityfunds.Theresultsare
showninthetablebelow.

Optimizedportfoliosincludingoneortwocommodityfunds
Allocation
DJP
DBC
PCRDX
CRSAX
SPY
AGG
ExpectedReturn
ExpectedVolatility
Correlto10YrTreasuryYield
BetawithrespecttoS&P500
GainRelativeto60/40

18.4%

11.8%
11.3%

17.5%
16.7%
60.0%
40.0%
5.93%
9.0%
38%
0.59
0.00%

42.6%
39.0%
6.24%
9.0%
35%
0.55
0.31%

42.3%
40.2%
6.24%
9.0%
37%
0.55
0.31%

42.9%
40.4%
6.24%
9.0%
29%
0.55
0.30%

18.6%
43.8%
37.6%
6.20%
9.0%
36%
0.56
0.27%

38.1%
38.8%
6.37%
9.0%
35%
0.55
0.43%

11.5%
11.7%
38.5%
38.4%
6.34%
9.0%
31%
0.55
0.40%

11.4%
11.0%
37.7%
39.9%
6.36%
9.0%
31%
0.55
0.43%

Includingasinglecommodityfundadded30basispointsperyeartotheexpectedreturnofa60/40
portfolio.Whilethisisnotanappreciableamount,itmustbeconsideredinlightofthecurrentlowyield
environment.Theadditionofcommoditiesrepresentsa5%increaseinexpectedreturnoverthe60/40
portfolio(0.3%/5.93%).Butobtainingthisexpectedbenefitrequires1718%allocationstoacommodity
fund.

Allowingtheoptimizertochoosetwocommodityfundshasagreaterdiversificationbenefit,providing40to
43basispointsinexpectedreturnusingcommodityallocationsof20%ormoreofthetotalportfolio.The
Ibbotsonstudysuggestedcomparablebenefitsatthoseallocationlevels.Buttheselevelsofallocationto
commoditiesarelikelytobetoohighformostadvisorsandclients.

REITsalsoprovideexposuretohardassets.TheIbbotsonstudydidnotincludeREITsinitsanalysis.WhenI
includeREITs,theresultslookmuchmorereasonable.

-6 Copyright 2014, Advisor Perspectives, Inc. All rights reserved.

OptimizedportfoliosincludingREITsandcommodityfunds
Allocation
DJP
DBC
PCRDX
CRSAX
SPY
AGG
ICF
RWR
ExpectedReturn
ExpectedVolatility
Correlto10YrTreasuryYield
BetawithrespecttoS&P500
GainRelativeto60/40

10.0%

7.7%
7.5%

9.7%
8.9%
60.0%
40.0%

5.93%
9.0%
38%
0.59
0.00%

37.1%
45.9%
8.7%
8.3%
6.34%
9.0%
27%
0.55
0.40%

32.9%
43.7%
6.9%
6.5%
6.44%
9.0%
29%
0.54
0.51%

32.7%
44.4%
6.9%
6.4%
6.44%
9.0%
30%
0.54
0.51%

33.9%
44.3%
6.7%
6.3%
6.43%
9.0%
26%
0.54
0.50%

9.9%
33.4%
43.1%
7.0%
6.5%
6.42%
9.0%
29%
0.54
0.48%

31.3%
42.6%
5.7%
5.2%
6.51%
9.0%
30%
0.54
0.57%

6.9%
7.4%
32.3%
42.3%
5.7%
5.4%
6.48%
9.0%
27%
0.54
0.55%

7.5%
6.8%
31.7%
43.2%
5.6%
5.2%
6.50%
9.0%
28%
0.54
0.56%

AddingallocationstotwoREITETFs(ICFandRWR)resultedinhigherreturnsandlowerallocationsto
commodities.Theresultingportfolioshave5057basispointsingreaterexpectedreturnperyearwitha
maximumallocationtocommoditiesof15.2%.Theportfoliosthatincludedasinglecommodityfundand
thetwoREITfundshadasmuchasa51basispointincreaseinreturnfora910%allocationto
commoditiesand1314%allocationtoREITs.

TheoptimalportfolioincludingREITsbutnotcommoditiesadded40basispointsinexpectedreturn.The
optimalportfoliosincludingcommoditiesbutnotREITsadded43basispointsperyearinexpectedreturn.
Whenbothwereincluded,themaximumtotalbenefitis57basispointsperyear.

Thesearemodestlevelsofincrementalgain,givenalloftheuncertaintiesinthistypeofanalysis.Onthe
otherhand,withthelowlevelofexpectedreturnfromstock/bondportfolios,a10%increasefromthe
baseline(0.57%vs.5.93%)isworthconsidering.ThemajorityofthisincreasecanbeachievedusingREITs
alone,however.

Conclusions

Abodyofresearchhasshownthatadiversifiedportfolioofcommodityfutureshistoricallydelivered
attractiveriskadjustedreturns.Commoditieshavealsoexhibitedlowcorrelationtoequitiesandbonds,
providingvaluablediversificationbenefits.Whilecommodityindicesandfundshavedeliveredunattractive
returnsinrecentyears,thecauseisunderstood.Mutedeconomicgrowtharoundtheglobehasresultedin
lowpriceinflationandreduceddemandforcommodities.Whengrowthandinflationreturn,history
suggestsanallocationtocommoditieswillprovideaneffectivehedge.Inthecurrentglobaleconomic
environment,anallocationtocommoditiesisbestviewedasadiversifierandasprotectionfroman
inflationshock.

Whileacollateralizedfuturesstrategyhashistoricallydeliveredattractivereturnscomparabletothatfrom
equities,thereisnoguaranteethatthisriskpremiumwillpersist.Mysimulationstreatedcollateralized
-7 Copyright 2014, Advisor Perspectives, Inc. All rights reserved.

commodityfundsashavingariskreturnrelationshipconsistentwithotherassetclasses,buttheirexpected
returnsarelowerthanhistoricalvalues.

Inthecurrentenvironment,thebestcourseofactionisamodestallocationtoacommoditiesfundeven
thoughmysimulationresults,consistentwithIbbotsonsfrom2006,suggestanallocationashighas23%.A
considerableportionoftheavailablegainsfromcommoditiescanbeaccessedbyREITs.Myanalysis
suggeststhata10%allocationtoadiversifiedcollateralizedfuturesstrategycanaddvaluetoaportfolioof
stocks,bondsandREITs.Butthelongtermincrementalreturnfroma10%allocationtocommoditiesand
REITsissmallapproximately10basispoints.Thegreatervalueofsuchanallocationisinsuranceagainst
inflation,alongwiththepotentialforequitylikereturns.

GeoffConsidineisfounderofQuantext(www.quantext.com)andthedeveloperofQuantextPortfolio
Planner,aportfoliomanagementtool.QuantextisastrategicadvisertoFolioInvesting,abrokeragefirm
specializinginofferingandtradingportfoliosforadvisorsandindividualinvestors

www.advisorperspectives.com

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-8 Copyright 2014, Advisor Perspectives, Inc. All rights reserved.