COMMODITY MARKETS PROJECT

Advantages of Having Commodities in Portfolio

Submitted to:
Ranjan Chakarborty

Submitted by:
Vaishak Anil F002
Rajan Singh F056
Aditi Goyal F017
Shalini Kumar F032
Abhishek Tater F062
Vansh Malik
Habil Bohra F011
Ankur Madaan F033
Objective
To identify the needs for having commodities to make it a diversified portfolio. We are
deducing this using a control and experiment portfolio. The control portfolio would only
consist of stocks and the experiment portfolio would consist of both stocks and
commodities. The experiment portfolio vs control portfolio would give a good analysis of
the risk -returns of having commodities in a portfolio

Commodities In A Portfolio

The concept of adding commodities exposure as a way of reducing portfolio volatility may seem
counterintuitive, but the main drivers of commodities prices often vary from those of other asset
classes, particularly bonds and securities. This makes commodities important as both diversifiers
and volatility reducers in a well-designed, risk-adjusted portfolio. Advisors and investors can
turn to the commodities sector as a potentially effective means of achieving higher risk-adjusted
returns in a portfolio.

Beta Vs. Alpha

The principles of "beta" and "alpha" have been much discussed in the world of modern portfolio
theory, particularly by academics and statisticians. Fortunately, these concepts are widely
understood and can often be utilized by professional money managers and ordinary investors
alike as a method to potentially achieve improved risk-adjusted returns in almost any-sized
portfolio. For purposes of this discussion, we will generally use the term "beta" to refer to the
volatility of an investment in relation to the broader market, and we will generally refer to
"alpha" as outperformance versus a comparable benchmark representing the broader market.
This report will not only try to explore the basic concepts of why and how commodities can be
beneficial to a portfolio's risk (beta) profile, but also explore certain easily implemented beta
optimization (alpha) strategies that may be able to improve results over time.
Why Commodities Work In A Portfolio
Why are commodities so popular? The answer is simple: Adding commodities "beta" in a
portfolio can, over time, actually reduce overall portfolio volatility and even have a slight
positive effect on overall absolute returns.
In the Morningstar study cited in Figure 1, by using a 28 percent exposure to a broad
commodities basket in a 40 percent bond, 32 percent stock and 28 percent commodities-weighted
portfolio, the volatility of the portfolio was reduced by 24 percent, from 11.6 percent to 8.8
percent. In this example, absolute returns actually increased slightly by 2.3 percent, from 8.7
percent to 8.9 percent (per year for the 20-year time period tested). Given this analysis, it is
understandable why institutional investors have effectively utilized commodities in their risk-
adjusted portfolios. Large institutions and managers can achieve this exposure through direct
investments in physical commodities and through the retention of professional futures traders.

Today's investors and asset allocators have a wide variety of commodities-based ETPs from
which to choose when determining their investment objectives; all can be accessed directly
through a normal securities account on major trading exchanges with no need for a futures
account or external futures manager.
Investors face some basic choices when adding commodities-based beta to their portfolio.
Primary among considerations should be the type of commodities exposure one wishes to
achieve. One must ask if a broad-based, multicommodity basket is most suitable, or might
exposure to a smaller, core group of commodities about which the investor has some knowledge
be best?
Most important for investors to remember when choosing a commodities-based ETP is that no
two benchmarks are alike; each has its own unique design and results will vary accordingly.
Spend some time looking into the design of the ETPs in the commodities sector to find the one
that best suits your investment needs.
Some multicommodity funds give investors equal weighting among a wide variety of
commodities; others assign weightings to commodities according to their scale of global
production or consumption rates. Many of the most popular of these indexes are heavily
weighted in favor of a particular sector, such as the S&P GSCI, with its fairly strong
concentration in energy. These funds allow immediate, generalized exposure to commodities and
offer a convenient way for investors not currently familiar with commodities to gain initial core
portfolio exposure.
In the single-commodity ETP sector, more narrowly focused products give investors the ability
to custom-design or supplement their commodities exposure. These funds often appeal to
investors wishing to overweight or underweight a core commodities holding, especially those
investors familiar with specific commodities or sectors such as energy, precious metals or
agriculture. Some of these funds are designed to efficiently capture short-term movements in the
price of an individual underlying commodity; others may be designed for longer-term asset
allocation exposure rather than for short-term trading results.

Benchmark Design And The Futures Curve: Contango And Backwardation

When first developed and introduced in the 1990s, multicommodity indexes/funds became
popular (and remain so today). This is due mainly to their ability to give nonfutures investors
direct exposure to commodities through indirect futures holdings via an index or fund.
These funds are sometimes referred to as "first generation" funds due to their concentration of
holdings in the very front of the futures curve. This is because their focus is generally more on
achieving direct exposure to the commodities and less on how efficiently the benchmark might
perform over time versus a given investor's time horizon and expectations.
These funds can be affected by issues unique to futures pricing called contango4 and
backwardation,5 which can have unpredictable effects on investor returns over time. Contango
and backwardation are generally more of a concern in the energy, agricultural and industrial
metals sectors than they are in precious metals. The latter category has minimal storage and
carrying charge costs associated with it compared with other commodities, where storage,
processing, spoilage and other costs affecting contango and backwardation can be substantial.
As the issues of contango and backwardation have come to the fore of the collective thinking of
the investor community in first-generation funds, a number of "next generation" funds and ETP
products have been introduced. These ETPs have benchmark holdings or trading methodologies
specifically designed to mitigate (as much as possible) the potential effects of contango and
backwardation. However, bear in mind the fact that contango and backwardation can never be
fully eliminated. Both are a fundamental element of commodities trading and are an important
factor when choosing a commodities-based ETP design that is right for one's needs.
Generally speaking, investors and asset allocators who want to add beta to their portfolio using
commodities will be buying and holding their selected commodities exposure long term. This
means that a next-generation commodities ETP, designed to mitigate contango and
backwardation, may be a more appropriate choice than a (possibly more widely recognized) first-
generation ETP. Conversely, an investor looking at shorter-term exposure to a commodities
sector (or sectors) may be better served by a first-generation ETP. Your investment's time
horizon is particularly important when implementing beta optimization (alpha) strategies through
ETPs.
Any combination of ETP choices can be effective, but in all cases, the benchmark design and
holdings of the ETP are what will drive returns more than any other factor.
Choosing Commodities Exposure For Beta Diversification
How might an investor go about choosing exactly what type of commodities exposure to include
in the beta portion of a portfolio? A good place to begin might be with some basic statistical
analysis. Generally speaking, correlation, when used in conjunction with portfolio analysis,
determines if the prices of assets included in the analysis move in the same direction, whereas
regression6 analysis examines if the movements of one asset can be explained by the movements
in another asset.
Many professional investors are well aware that price movements in precious metals are
generally not well correlated with the performance of stocks and bonds. However, it often comes
as a surprise to investors that many commodities in the agricultural sector have price movements
that are less correlated with stocks and bonds than do other well-known commodities. Figure 2
illustrates the 20-year price correlation of 13 major commodities to the S&P 500.7

Precious metals and energies can be effective beta-enhancing components in a diversified

portfolio, and the popularity and presence of these two commodities sectors in many portfolios is
widely known. But analysis shows that over time, the price movements of energies seem to be
more closely correlated with stocks and bonds than are the price movements of agricultures and
precious metals. Regression analysis, which relates to correlation by showing how much the
movement of something (in this case, specific commodities) is directly affected by the
movements in a comparable benchmark (in this case, the S&P 500) can often explain correlation
patterns. In fact, longer-term regression analysis of 13 major commodities consistently shows
gold, sugar, soybeans and corn as the least directly affected by the performance of the S&P 500
Index.
Specifically, when one performs a regression analysis of the S&P 500 Index over five-, 10- and
20-year periods8 against the 13 commodities available in the single-ETP format, those that are
the least tied to the S&P 500 are consistently precious metals and agricultural commodities. (See
Figure 3.) In fact, sugar is historically less tied than gold over the last 10 years, and soybeans are
less tied than gold over the past five years.
As previously discussed, investors seeking exposure to commodities have easy access to a
variety of commodities-based ETP products. They can choose among several multicommodity
ETPs or they can customize their exposure using single-commodity funds. Again, be certain to
study the underlying benchmark of your ETP choices, because benchmark design more than any
other factor will be the true source of your expected performance.
Commodities is a hedge against inflation
As shown in the graph below the white line indicates the WTI price curve over 5 years and the
red line indicates the CPI inflation curve. As we can see the WTI price curve is a leading
indicator of CPI inflation curve and can be a good hedge for inflation.

Conclusion
Commodities are being used very effectively as beta diversifiers in many portfolios. As
addressed in the Morningstar study cited above, the inclusion of commodities in a portfolio can
reduce volatility over time without negatively impacting overall returns. Investors now have
access through a wide variety of ETP products to a range of principal commodities. These ETPs
can differ significantly in benchmark design, which is the main driver of returns to the investor.