Investment case for commodities?

Myths and reality

Vanguard research

March 2010

Executive summary. Commodities are one of the least understood asset classes. Some investors wonder how owning a chunk of steel or a bushel of corn could provide them with any real return, particularly in times of deflation. Still others contend that the high historical returns for commodities are primarily the result of two commodity bubbles, and that, excluding those abnormal periods, commodities have had only poor results. Then, too, some see commodities as highly volatile and as too risky for most investors. This paper describes the fundamental properties of commodities to help institutional investors evaluate the case for investing in them. One challenge in understanding commodities as an asset class is the absence of a long data series on the past performance of commodity futures.1 To address this problem, Vanguard has recently constructed an equally weighted, well-diversified commodities return series, using

Author
Geetesh Bhardwaj, Ph.D.

1 For example, historical data on the well-diversified DJ (Dow Jones)-UBS Commodity Index (henceforth, DJ-UBSCI) are available only since 1991 (also, since the index was launched in 1998, it has a significant backfill). For Institutional Investor Use Only. Not for Public Distribution.

Connect with Vanguard > www.vanguard.com > global.vanguard.com (non-U.S. investors)

long historical commodity futures data beginning in 1959.2 Our aim here is to describe the basic properties of commodities, and not to provide an investable alternative to existing commodity indexes.3 But, as with historical analysis of any asset class (e.g., stocks, bonds, or short-term debt), it is difficult to know how the existence of a large and institutionally dominated market would have affected past returns; for similar reasons, investors need to be mindful that past returns do not guarantee future performance.

Can commodities rightfully be considered an asset class? Can a commodities investor expect to earn any real return, or were the two historical bubbles in commodities their only periods of outperformance? Are commodities too volatile for most investors to touch?

have, in fact, experienced long periods of significant returns for investors, as well as sequences of booms and busts similar to equities; there is thus little merit in the argument that relatively high long-term average returns of commodity futures are solely a result of a few brief abnormal periods of high returns. First, we introduce the concept of commodity futures and explore the theoretical foundations of why a long-only investor may expect to earn a return for taking such a position. We then construct a commodities return series for a long-only investment in commodities futures, including detailed analysis of the data. Next, we compare the results of investing in commodity futures versus physical commodities, as well as the historical performance of commodity future returns versus equity returns. Finally, we look at the diversification benefits of commodity futures from a portfolio perspective.

This paper addresses these and other questions as it seeks to separate myth from reality in helping investors evaluate the case for commodity investing. For instance, as we describe, an investor actually gains exposure to commodities as an asset class by investing in commodity futures, and not by investing in physical commodities. The fundamental economic reason long-only investors in commodity futures have historically been expected to earn a risk premium is that long investors have provided price insurance to producers of commodities, who hedge price risk by taking the short side of positions in the futures market. Moreover, commodity futures

Notes on risk: All investments are subject to risk. Investments in bonds are subject to interest rate, credit, and inflation risk. Foreign investing involves additional risks, including currency fluctuations and political uncertainty. Diversification does not ensure a profit or protect against a loss in a declining market. Past performance is no guarantee of future returns. The performance of an index is not an exact representation of any particular investment, as you cannot invest directly in an index.

2 Our commodities return series represents the broad commodity market; given equal weights, no one single commodity or sector can drive the results. 3 We believe that one needs a long historical data record to understand the fundamental properties of any asset class.

Basics of commodity investment

A commodity futures contract is a standardized agreement to buy (or sell) a prespecified amount of a commodity at a future date, called the maturity date. The price of the contract (the futures price) is effectively the price that the seller of the commodity will receive at the maturity date, and is determined on a futures exchange by the forces of demand and supply.4 As stated early in this paper, its important to appreciate that commodity futures do not necessarily represent direct exposures to actual commodities. A long investor who agrees to buy a physical commodity at a future date may not have the commodity actually delivered to him or her, because the investor has the option to sell the futures contract before the actual date of physical delivery.
Determining the futures price To understand how commodity futures returns are derived, one must first understand how a futures price is determined. The most important element making up the futures price is the spot price, that is, the price that market participants expect to prevail when a futures contract matures. If market participants expect the future spot price to be much higher than the current spot price (due to future expected demand and supply for the commodity), then the futures price will be higher than the current spot price; otherwise, the futures price will be lower than the current spot price (all else being equal). It is important to emphasize here that the futures price is set in relation to the spot price that is expected to prevail at the time of the maturity of the futures contract, and not the current spot price.

all futures investors face. If the realized spot price at maturity ends up higher than the futures price, then the long investor will make a profit; otherwise, he or she faces a loss. So how can long-only investors consistently earn a risk premium in this market? The only way this is likely to happen is if the futures price, on average, is set below the expected spot price that obtains at maturity. We would expect this to occur if there are sellers of commodity futures in the market that are willing to systematically accept a lower-thanexpected price for the underlying commodity, in exchange for the futures buyers assurance of a certain price at maturity. These sellers are willing to pay a premium to insure against the price risk. This premium can be thought of as equaling the difference between the futures price at which they sell in the futures market, and the future spot price they would otherwise expect to be paid. Much academic work has been done on this concept since the 1930s, when both Keynes (1930) and Hicks (1939) developed the theory of normal backwardation, which holds that futures prices are set below expected future spot prices. To understand Keynes and Hickss theory, consider a producer of corn who wants to insure against the risk that prices could fall at harvest time (such a participant is called a hedger). The corn producer can obtain such insurance by selling corn futures to lock in a predetermined price for his crops. Participating on the other side of the trade are long investors (called speculators) who provide the insurance for the price of corn by buying futures contracts. These long investors, however, demand a risk premium for bearing the risk of future price fluctuations. Thus, the long investors would require that the futures price be set at least somewhat below the expected future spot price.

A spot prices deviation at maturity from what was expected when the futures contract was issued is by definition subject to risk, and this is the risk that

4 At the end of each trading day, gains and losses during the day are settled by the two parties to the contract via transfers from their margin accounts, through daily mark to market. To understand the accounting, consider the hypothetical example of a buyer and seller entering into an oil futures contract. Suppose the current futures price of oil for delivery the subsequent month is $70 (U.S. dollars). At the time of delivery, if the spot price turns out to be $100 dollars, the seller of the commodity will receive $100 for oil. However the seller, through daily mark to market, would have paid the buyer $30, thus effectively exchanging oil at $70. On the flip side, if at the time of delivery the spot price is $50, the seller of the commodity will receive $50 for oil. Further, the seller, through daily mark to market, would also have received $20 from the buyer, again effectively exchanging oil at $70.

The normal backwardation theory implicitly assumes that the number of producers requiring hedging outweighs the number of consumers requiring similar hedging in the market. For example, suppose iron ore were produced only by mining companies and used as an input only by steelmakers. If the hedging demands of both types of firms were equal, there would be no reason to assume one side of the futures contracting arrangement (long or short) would receive a premium for buying or selling an iron-ore future. However, if one side of the market (either the producer or consumer) is more risk-averse than the other, the more risk-averse side clearly would be willing to provide an insurance premium to the other side of the transaction. Gorton and Rouwenhorst (2006) have also recently studied this topic, and summarized the fundamentals of commodity futures returns as follows: 1. The expected return to the long investor in commodity futures in excess of the risk-free rate of return is the risk premium. The return realized by the long investor is the risk-free rate, plus the (insurance) risk premium, plus any unexpected deviation of the future spot price from the expected future spot price at the time the long position was established. 2. A long position in futures is expected to earn a positive risk premium as long as the futures price is below the expected spot price at maturity. A risk premium may exist and be earned regardless of whether the futures price is higher or lower than the current spot price for the commodity in question. 3. Expected trends in spot prices are not a source of return to an investor in futures, because that would assume successful market-timing on the part of the futures investor.
Confusion about terminology. Backwardation and another term, contango, have often been used to characterize the current state of the futures market. Yet, use of these terms has resulted in some

confusion. Contango commonly refers to a market in which futures prices are higher than the current spot pricethat is, the term structure of the futures curve is upward sloping. In backwardation, futures prices are lower than the current spot, and the term structure of the futures curve is downward sloping. The definitions just cited, as well as those used by the U.S. Commodity Futures Trading Commission,5 refer to the slope of the futures curve at a point in time, and not to the movement of futures prices over the life of a contract. However, as stated earlier, the theory of normal backwardation contends that futures prices are set below expected spot prices at maturity. This theory is about futures prices relative to expected spot prices. However, the prevailing terminology describes futures markets by referring to futures prices relative to the current spot. The use of the term backwardation to characterize the state of the futures market vis--vis the current spot price has led to a widespread, but false, belief that the theory somehow implies that a commodity futures return premium exists only when markets are in backwardation. As emphasized earlier in this discussion, however, this is not the case. Further, given the preceding definitions of contango and backwardation as relative to the current spot price, the natural state of virtually all (historically, this has actually occurred close to 70% of the time) commodity futures markets is reasonably expected to be in contango. This is implied by the existence of a cost of carry, according to which those holding a physical commodity must pay for storage and other expenses, coupled with a simple arbitrage. Arbitrage in this case is a financially equivalent alternative to buying a commodity future and selling it at expiry. In an arbitrage transaction, the investor buys the underlying physical commodity now in the spot market, stores it until the futures contract maturity date, and then sells it in the spot market. If the commodity is costly to store (there is a cost of carry), then investors ability to make this alternative trade should tend to push futures prices higher than the current spot price, all else equal, which would

5 The U.S. Commodity Futures Trading Commission (CFTC) defines these market conditions as: Backwardation : Market situation in which futures prices are progressively lower in the distant delivery months and Contango : Market situation in which prices in succeeding delivery months are progressively higher than in the nearest delivery month. Source: http://www.cftc.gov/educationcenter/glossary/glossary_b.html.

Figure 1.

Commodity risk premium in a contango market

Figure 2.

Commodity risk premium in a backwardation market

Inception (t )

Expiration (T )
$110: Expected spot price (ST )

Inception (t )
$115: Current spot price (St ) Expected spot price decline, $5

Expiration (T )

Expected risk premium, $5 Expected spot price rise, $10

$105: Futures price (Ft )

$110: Expected spot price (ST ) Expected risk premium, $5

$100: Current spot price (St )

$105: Futures price (Ft )

Note: This hypothetical illustration does not represent the return on any particular investment. Source: Vanguard.

Note: This hypothetical illustration does not represent the return on any particular investment. Source: Vanguard.

imply contango. This logic, coupled with a mistaken belief that commodities-futures risk premiums cannot exist when markets are in contango, has led some to conclude that all commodities futures returns come from the few market events when the market is in backwardation (relative to the current spot price). This argument fails to recognize that prevailing terminology compares futures prices with current spot prices, whereas the theory of normal backwardation suggests a relationship between the futures price and the expected spot price at maturity. To illustrate how a risk premium can potentially be obtained when the market is in contango, consider the following hypothetical example (see Figure 1). Suppose the current spot price is $100 and the expected spot price is $110. The theory of normal backwardation suggests that the futures price should be less than the expected spot price. Thus, suppose the futures price is $105. This implies that the expected risk premium is $5 ($110 $105 = $5). Notice, however, that the market is in contango: that is, the futures price is greater than the current spot price. This example shows that normal backwardation can be present while a futures market

is in contango; the long-only investor would expect to earn a premium of $5, although the realized return will of course be different from $5 if the spot price at maturity is different from the expected $110. Now consider an example in which the futures markets are in backwardation (see Figure 2 ). Suppose the current spot price is $115 and that the expected spot price is $110. The theory of normal backwardation suggests that the futures price should be less than the expected spot price. Suppose the futures price is $105thus, the expected risk premium would be $5. This example also illustrates a market condition in which there is deflationary pressure, since the spot price is actually declining from $115 to $110; however, the futures investors are expected to get a positive risk premium as a result of normal backwardation. In summary, a long-only futures investor in a commodity market can expect to earn a positive risk premium by providing valuable insurance, if producers or other risk hedgers are willing to pay for such insurance regardless of whether markets are in backwardation or contango. The positive risk premium is the reward for assuming the price risk.

74% Did not opt

18% Partial opt-

8% Full opt-out

10-year excess returns 10-year excess returns 10-year excess returns 1-year excess returns: 1-year excess returns: 1-year excess returns:

Historical data and construction of commodities return series

Unfortunately, a long historical data series on the performance of commodity futures as an asset class is not available. For example, historical data on the well-diversified DJ (Dow Jones)-UBS Commodity Index (henceforth, the DJ-UBSCI) are available only from 1991. Yet, we believe that to fully understand an asset classs fundamental properties, longer-term historical data are necessary. Therefore, to carry out a robust historical analysis of the behavior of commodity futures markets, we have constructed a commodities return series extending back in history to August 31, 1959.
Figure 3 lists the commodities that make up our return series and the inception dates of futures contracts for each. In all, the return series contains 30 commodities, broadly characterized in seven sectors (energy, precious metals, grains, animal products, softs, industrial materials, and industrial metals). Figure 3 also reports the cumulative annualized excess returns (beyond the 3-month U.S. Treasury bill return) for each commodity since the start of its futures contract through April 30, 2009. The last column reports t-statistics denoting significance of the average excess return. Thus, we tested for the statistical hypothesis that, on average, the excess returns were positive. We found this to be true for only 5 out of the 30 commodities (at a 95% significance levelsee the asterisked commodities in the figure)a result that supports the well-documented high volatility of individual commodity futures returns.

ruled out use of leveraging), we incorporated the 3-month U.S. Treasury bill return into the price return. Numerous academic studies have analyzed the commodity markets using equally weighted returns of a commodity basket. For example, Bodie and Rosansky (1980) constructed an equally weighted commodities return series using quarterly data from 1950 through 1976. Fama and French (1987) reported average monthly excess returns for 21 commodities as well as for an equally weighted portfolio. Unless otherwise noted, from here on, when referring to commodities futures returns, we are referring to returns as measured by the performance of our newly constructed commodities return series.

Commodity futures versus spot returns: Case for insurance-risk premium

The previous section included a hypothetical example of how an investor in commodity futures could potentially expect to earn a positive return when commodity prices are falling. To illustrate the impact of an insurance-risk premium in a deflationary market, consider the crude oil market. Figure 4, on page 8, compares the cumulative returns of a fully collateralized investment in crude oil futures with that of physical crude oil from April 30, 1983, through April 30, 2009. Taking a conservative approach, we ignored the costs of physical storage, insurance, and shipping, and so on, which would otherwise have reduced the returns of the physical crude. Nevertheless, despite a high monthly correlation between spot and futures returns (0.97), the total average annual return for a spot investment (2.1%) was but a fraction of the futures average annual return (11.6%). In fact, for a significant portion of this time (April 30, 1983December 31, 1998), spot oil prices were actually declining. For the full, nearly 16-year, period, active spot investment produced an annual total return of 5.7%, while the annual return of futures investments over the same period was 7.1%. This example illustrates the case for an insurance-risk premium for long-only investors in commodity futures, even during deflationary market conditions.

Our commodities return series is an equally weighted average of these 30 commodities; the series is well-diversified and represents the broad commodity market. The accompanying Appendix summarizes the steps we used in constructing the return series and the details of our analysis. Given the return series diversified nature, no single commodity or sector can drive the results. To derive the total returns that would result from holding a fully collateralized commodity futures position (we

Figure 3.

Commodity futures and coverage data for our commodities return series Cumulative annualized excess returns (inception through April 30, 2009) 2.7% 6.1% 0.4% 0.4% 7.7% 5.4% 1.2% 6.4% 1.5% 1.4% 5.5% 2.5% 4.4% 7.9% 13.5% 0.9% 6.3% 0.4% 0.3% 0.5% 13.5% 7.8% 1.7% 3.8% 0.9% 4.6% 3.6% 11.2% 4.4% 0.5%

Name Aluminum Coal Cocoa Coffee Copper Corn Cotton Crude oil Feeder cattle Gold Heating oil Lean hogs Live cattle Lumber Natural gas Nickel Oats Orange juice Palladium Platinum Propane Rough rice Silver Soybean meal Soybean oil Soybeans Sugar Unleaded gasoline Wheat Zinc

Contracts start date 6/1/1987 7/12/2001 7/1/1959 8/16/1972 7/1/1959 7/1/1959 7/1/1959 3/30/1983 11/30/1971 12/31/1974 11/14/1978 2/28/1966 11/30/1964 10/1/1969 4/4/1990 4/23/1979 7/1/1959 2/1/1967 1/3/1977 3/4/1968 8/21/1987 8/20/1986 6/12/1963 7/1/1959 7/1/1959 7/1/1959 1/4/1961 12/3/1984 7/1/1959 1/3/1977

Sector Industrial metals Energy Softs Softs Industrial metals Grains Industrial materials Energy Animal products Precious metals Energy Animal products Animal products Industrial materials Energy Industrial metals Grains Softs Precious metals Precious metals Energy Grains Precious metals Grains Grains Grains Softs Energy Grains Industrial metals

t-Statistic 0.02 0.18 0.98 1.17 2.83* 0.89 0.47 1.78 1.08 0.15 1.76 1.49 2.21* 0.81 0.08 1.04 0.58 0.89 1.08 1.03 2.16* 0.89 0.66 1.88 1.13 2.01* 0.83 2.33* 0.52 0.54

Notes: The second column provides the date when price quotes were first available for various commodities. The fourth column reports cumulative annualized excess returns (over the 3-month Treasury bill return). The last column reports t-statistics for testing the statistical significance of the average excess return (the five commodities found to have significant excess returns are denoted by an asterisk). Sources: Vanguard calculations, based on Commodity Research Bureau; Datastream, Thomson Reuters.

Figure 4.

Cumulative returns of long crude oil futures versus long crude oil (log scale): April 30, 1983, through April 30, 2009

Cumulative returns 10,000

1,000

100

10

1983

1985

1987

1989

1991

1993

1995 Year

1997

1999

2001

2003

2005

2007

2009

Crude oil futures

Crude oil spot

Sources: Vanguard calculations, based on Commodity Research Bureau data.

Figure 5.

Cumulative real returns of historical commodity futures and equities (inflation-adjusted): August 31, 1959, through April 30, 2009

Cumulative real returns 3,000 2,500 2,000 Did not opt out 1,500 1,000 500 0 1959 1964 1969 1974 1979 Year Commodities Equities 1984 1989 1994 10-year excess returns: Europe 10-year excess returns: U.S. 10-year excess returns: Global 1-year excess returns: Europe 1-year excess returns: U.S. 1999 2004 1-year excess returns: Global Partial opt-out Full opt-out

Note: Equity returns for this and subsequent figures in this paper are based on the following equity series: pre-1971: Standard & Poors 500 Index; 1971 through April 22, 2005, Dow Jones Wilshire 5000 Index; April 23, 2005, through April 30, 2009, MSCI US Broad Market Index. Sources: Vanguard calculations, based on Commodity Research Bureau; Datastream, Thomson Reuters.

Figure 6.

High historical real returns for commodities: A result of two commodity bubbles? (August 31, 1959, through April 30, 2009)

Cumulative real returns 3,000 2,500 2,000 1,500 1,000 500 0 1959 1964 1969 1974 1979 1984 Year 1989 1994 1999 2004
January 31, 19721973: 58.5% August 31, 19591971: 7 .7% January 31, 2004June 30, 2008: 19.5% July 31, 2008 April 30, 2009: 51.5%

January 31, 19742003: 9.1%

Note: Return figures are average annual nominal returns for the period. Sources: Vanguard calculations, based on Commodity Research Bureau; Datastream, Thomson Reuters.

Bursting the commodities bubbles?

As noted early in this paper, some investors hold that commodities high historical returns can be attributed primarily to two commodity bubbles, and that, outside of those periods, returns are unattractive. This sections discussion reveals that this argument is false, based on an analysis of the historical record. For the period August 31, 1959, through April 30, 2009, commodity futures (i.e., our commodities return series) have produced an average annual return of 9.8%, which is comparable to the 9.0% average annual return for U.S. equities for the same period. Figure 5 plots the cumulative real returns (net of inflation) of commodities and equities for August 31, 1959, through April 30, 2009.
Identifying historical subperiods for the commodities return series To isolate historical episodes for commodity returns, we divided the 51-year period covered by our commodities return series into five subperiods, to capture the different cycles experienced by the

commodity futures markets. Figure 6 plots these subperiods and the corresponding annual returns for investors. Over the first subperiodAugust 31, 1959, through December 31, 1971the average annual return for commodity futures was 7.7%, similar to the 8.0% average annual return of U.S. equities for the same period. The next subperiod January 31, 1972, through December 31, 1973 saw commodities futures return 58.5%. Clearly, this was a time of abnormally high returns for Did not opt out commodities, particularly compared with the 2.0% Partial opt-out return of U.S. equities for the same period. opt-out Over Full the third subperiodJanuary 31, 1974, through December 31, 2003commodity futures returned 10-year excess returns: Europe 9.1%, a few points below the corresponding equities 10-year excess returns: U.S. result of 12.3%. For the next subperiodJanuary 31, 10-year excess returns: Global 1-year excess returns: Europe 2004, through June 30, 2008commodity futures 1-year excess returns: U.S. advanced 19.5%, a high result compared with the 1-year excess returns: Global corresponding equities return of 6.0%. Over the final subperiod analyzedJuly 31, 2008, through April 30, 2009commodity futures returned 51.5%, a low result compared with the corresponding equities return of 35.1%. (Note: All returns in this paragraph are average annual returns for the periods stated.)

Figure 7.

Selected individual commodity returns: 19721973 Average annual returns (January 31, 1972, through December 31, 1973) 52% 18% 17% 46% 36% 51% 70% 82% 113% 81% 29% 81% 4% 38% 16% 99% 56% 59%

Commodity Silver Platinum Live cattle Lean hogs Feeder cattle Corn Soybeans Soybean oil Wheat Soybean meal Oats Cocoa Coffee Sugar Orange juice Cotton Lumber Copper

management system. It should be noted, however, that the high returns of commodities for this period cannot be attributed directly to fluctuations in the price of gold, as gold futures contracts were not introduced until 1975 and thus were not part of the equally weighted commodities return series in 19721973.6 The other major historical event of 19721973 was the first oil shock: In October 1973, members of the Organization of Arab Petroleum Exporting Countries (OAPEC, consisting of the Arab members of OPEC plus Egypt and Syria) proclaimed an oil embargo. Again, as in the case of gold, no energy futures were traded in the 1970s; as indicated in Figure 3, crude oil contracts were not available until 1983. Thus, to claim that the high prices of gold and energy were responsible for commodity futures returns in the period is incorrect. To better understand the period, we looked at the average annual returns of individual commodities for the two years (see Figure 7). As the figure shows, no single commodity caused the high returns. Wheat garnered the best return, but other grains also experienced unusually high results. Gorton, Hayashi, and Rouwenhorst (2008) postulated that these high returns were generated by broad inventory shortages in a number of commodities, which led to higher uncertainty in the market, greater risk for long investors to insure, and temporarily higher risk premiums for long investors. Thus, according to this theory, these exceptional returns were the result of fundamental factors, and were not speculative in nature. Supporting the view that this isolated period of rocketing returns was not a bubble is that there was no corresponding correction, no subsequent crash in returns to support the notion of a bubble to begin with.

Sources: Vanguard calculations, based on Commodity Research Bureau; Datastream, Thomson Reuters.

The bubble of the early 1970s As stated, it has been argued that two of the five subperiods19721973 and 20042008 are commodity bubbles. To analyze this historical phenomenon further, we examined these two periods more closely.

The first period, January 31, 1972, through December 31, 1973, can be associated with two major events in the history of finance. The first event was the fall of the Bretton Woods monetary

6 Even after adjusting for inflation, the overall return for commodities for the period was 50.1%.

10

The bubble of the early 2000s Over the second historical period (January 31, 2004, through June 30, 2008), commodities experienced annual returns of 19.5%. Figure 8 reports selected commodity-level average annual returns for this period. Clearly, the returns were dominated by the energy sector; however, copper, oats, soybean oil, silver, and platinum also had impressive returns. In contrast to the 1970s, commodity futures returns underwent a dramatic correction during the period July 2008 through April 2009, which strongly suggests that there was a significant bubble component to the 20042008 returns. Nevertheless, if we ignore the period of the first bubble (January 31, 1972December 31, 1973), commodity futures produced a solid average annual return of 8.7% for the period August 31, 1959December 31, 2003. If we further ignore both bubbles from the sample (while retaining the recent 20082009 correction), commodity futures have produced an average annual return of 7.1% for the period August 31, 1959, through April 30, 2009 (taking out 19721973 and January 31, 2004, through June 30, 2008). These data support the view that high historical returns for commodities cannot just be attributed primarily to two commodity bubbles, and that, outside of those periods, long-only investors still have earned significant positive returns. Commodity futures versus equities: Comparing returns and volatility As the preceding analysis suggests, there is little validity to the claim that a few historical periods have determined returns for commodities futures. In fact, investors can point to a long period of substantial returns from commodities futures. Clearly, the early 1970s was a unique time for commodities. Although we have refuted the notion that 1972 and 1973 represented a bubble, one still has to question whether that kind of return can happen again.

Figure 8.

Selected individual commodity returns: 20042008 Average annual returns (January 31, 2004, through June 30, 2008 33% 36% 19% 33% 26% 38% 19% 26% 27% 19% 11% 2% 15% 8% 17% 20% 6% 13% 23% 12% 18% 10% 8% 12% 9% 14% 49% 16% 16% 15%

Commodity Crude oil Heating oil Natural gas Gasoline Coal Propane Gold Silver Platinum Palladium Live cattle Lean hogs Feeder cattle Corn Soybeans Soybean oil Wheat Soybean meal Oats Rough rice Cocoa Coffee Sugar Orange juice Cotton Lumber Copper Zinc Nickel Aluminum

Sources: Vanguard calculations, based on Commodity Research Bureau; Datastream, Thomson Reuters.

11

Figure 9.

Twelve-month returns for commodity futures versus equities: May 31, 1960, through April 30, 2009

Returns 60% 40 20 0 20 40 60 April 1961 April 1965 Commodities April 1969 April 1973 Equities April 1977 April 1981 April 1985 April 1989 April 1993 April 1997 April 2001 April 2005 April 2009

Sources: Vanguard calculations, based on Commodity Research Bureau; Datastream, Thomson Reuters.

If we ignore the high returns of the 1970s, the period January 31, 1980, through April 30, 2009, provided average annual commodity returns of 6.2%, as opposed to 10.3% for U.S. equities; however, during this period, our analysis shows that Source: Vanguard, 2009. commodities had 25% lower volatility than equities (sources: calculations based on Commodity Research Bureau; Datastream, Thomson Reuters). This brings us to a more in-depth look at returns and volatility for commodity futures versus equities. As reported in the previous section, average annual historical returns for commodity futures (9.8%) and U.S. equities (9.0%) are comparable. To compare the performance of the two asset classes more closely, Figure 9 plots their historical 12-month returns from May through April (that is, the first 12-month period is defined as beginning on May 31, 1960, and the

final 12-month period ends on April 30, 2009, just to include the last data point in our sample, which is April 2009; the results are similar, however, if we define the 12 months as the calendar year). This graph is also important to address the myth that commodities have returns only once in 20 years, and then only poor returns for the next 20 years. At first glance, its difficult to tell in Figure 9 which plotted time series is commodities futures and which one is equities. The giveaway is the outlier not 1972 in opt out Did and 1973, in which commodities had returns opt-out of more Partial than 50% in one year. The figure revealsFull opt-out that both commodities and equities have had multiple years of returns in the 20%40% range. These multiyear 10-year excess returns: Europe runs contradict the view that one has excess returns: U.S. 10-year to endure zero 10-year excess returns: Global returns for decades before experiencing any positive 1-year excess returns: Europe returns in commodities.
1-year excess returns: U.S. 1-year excess returns: Global

12

Figure 10.

Histogram of commodity futures and equity monthly returns: August 31, 1959, through April 30, 2009

Returns 60%

40

20 Volatility

0 < 20% 20%, 15% 15%, 10% 10%, 5% 5%, 0% 0%, 5% 5%, 10% 10%, 15% 15%, 20% > 20%

Equities: slightly longer negative tail

Commodities: slightly longer positive tail

Sources: Vanguard calculations, based on Commodity Research Bureau; Datastream, Thomson Reuters.

Figure 10 plots a histogram of monthly returns for commodities and equities, and Figure 11 shows summary statistics of the monthly data. Several things stand out: First, equities have a slightly longer negative tail, and commodities have a slightly longer positive tail. Second, while equities have returns that are comparable to those of commodities futures, they have had higher volatility. Third, commodities futures have positive skewness, while equities have negative skewness.

is no longer valid, since the correlations have increased significantly; further, they claim there are no diversification benefits during deep recessions.

Figure 11.

Comparing commodity futures and equity monthly returns: Summary statistics (August 1959 through April 2009) Commodity futures Did not opt out Equities

Potential diversification benefits of commodity futures

Advocates of commodity futures have argued that commodities provide diversification because of their low correlation with equities and bonds, while critics point out that the historical diversification argument

Monthly average returns Standard deviation Skewness

0.85% Partial opt-out 0.82% 3.70% 0.26

Full opt-out

4.40% 0.66

10-year excess returns: Europe Sources: Vanguard calculations, based on Commodity Research Bureau; 10-year excess returns: U.S. Datastream, Thomson Reuters. 10-year excess returns: Global 1-year excess returns: Europe 1-year excess returns: U.S. 1-year excess returns: Global

13

Figure 12.

Average monthly returns for domestic equities, commodity futures, and international equities during their 12-worst and 12-best months (selected periods) Worst 12 equity months Best 12 equity months Domestic Commodity equity returns futures returns 11.7% 7.5% 0.7% 1.6% International equity returns 6.6%

Period August 31, 1959April 30, 2009 January 31, 1999April 30, 2009

Domestic Commodity equity returns futures returns 12.6% 9.6% 1.1% 2.7%

International equity returns 9.7%

Worst 12 commodity futures months Period August 31, 1959April 30, 2009 January 31, 1999April 30, 2009 Domestic Commodity equity returns futures returns 4.0% 4.9% 9.8% 7.4% International equity returns 7.1%

Best 12 commodity futures months Domestic Commodity equity returns futures returns 1.4% 0.1% 12.2% 6.9% International equity returns 1.5%

Notes: International equities are represented by the MSCI EAFE + EM Index. As this index does not go back to the 1950s, the international equity returns are reported only for the more recent sample. Sources: Vanguard calculations, based on Commodity Research Bureau; Datastream, Thomson Reuters.

During negative shocks for equities This section first addresses the potential diversification benefits of commodities during negative shocks for equities, when the diversification benefits really matter. Figure 12 reports the average monthly returns for domestic equities, commodities, and international equities for months when these securities experienced extreme negative and/or positive shocks. The analysis covers two time periods: the full historical sample from August 31, 1959, through April 30, 2009 (the figure doesnt include international equity returns for this period), and the final decade starting January 31, 1999. For the longer historical period, while the average monthly return for the worst 12 domestic-equity months was 12.6%, commodities futures declined at a much smaller average monthly rate of 1.1%. The relative picture is not as clear over the final decade: The worst 12-month average monthly

return for domestic equities was 9.6% (international equities, 9.7%), while for the same 12 months, commodities lost an average of 2.7% per month. Figure 12 indicates that even though commodities experienced modest declines for the worst months of domestic equities, commodities still provided some diversification benefit, since for the same months international equities declined 9.7% per month. Of course, commodities have not always performed well during equity-market downturns; thus, for investors concerned about worst-case outcomes, diversifiers such as cash may be more effective. However, the significantly lower overall returns for holding cash make the reliable protection it offers more costly over time.

14

Correlation of U.S. equities with commodities versus international stocks What about the correlation of monthly U.S. equity returns and commodity futures returnsand, for further comparison, of domestic equities and international equities? The results of our analysis in Figure 13 show that the historical correlation of U.S. equity and commodity futures returns has been very low; for the period August 31, 1959, through April 30, 2009, the correlation was only 0.13. However, the correlation has risen steadily over time. For January 31, 2001, through April 30, 2009, the correlation was much higher, at 0.37. Many investors confidently include exposure to international equities for diversification purposes; however, the correlation of international equity returns with U.S. equities has also increased over time. From January 31, 2001, through April 30, 2009, the correlation of international equity returns with U.S. equities was 0.90, far higher than the 0.37 for commodity futures. The purpose of this analysis is not to suggest that investors should abandon international stocks as potential diversifiers in favor of commodities; after all, commodities have been experiencing increasing correlation with equities over time. Commodity futures can lessen volatility of all-equity and stock/bond portfolios Another way to characterize the diversification benefits of commodity futures is to analyze the impact of including commodities futures on the historical volatility of a diversified portfolio. Figure 14, on page 16, reports the average annualized change in portfolio volatility as commodity futures are added to the asset mix. We considered two hypothetical base portfolios, one all equities and the other 60% equities/40% bonds (in the second example, as we added commodities to the portfolio, we assumed the mix of stocks and bonds in the rest

Figure 13.

Comparing correlation of domestic equities with commodities, international equities (selected periods)

Correlation 100%

80

60

40

20

0 Aug. 1959 Jan. 1971 April 2009 April 2009 Jan. 1981 April 2009 Jan. 1991 April 2009 Jan. 2001 April 2009

Correlation of U.S. equities with commodities Correlation of U.S. equities with international equities

Sources: Vanguard calculations, based on Commodity Research Bureau; Datastream, Thomson Reuters.

of the portfolio was left constant, at 60%/40%). Figure 14 is based on data from January 31, 1974, through April 30, 2009 (however, results are similar for the full historical period beginning in 1959). For this exercise, we excluded the market conditions of the early 1970s to show that, as with returns, diversification benefits are not dependent on a few historical periods. In our hypothetical example, adding commodities to the portfolio clearly had the potential to reduce the portfolios volatility. Even for the 60% stocks/40% bonds portfolio, which has much lower volatility than the all-equity portfolio,

15

Figure 14.

Average annualized change in portfolio volatility as a result of adding commodities: January 31, 1974, through April 30, 2009

Annualized volatility change relative to no-commodities portfolio 4%

standard deviations, and Sharpe ratios for the allequity and 60%/40% equity/bond portfolios. The next two columns report total returns for these two portfolios after adding a 20% exposure to commodities. In this hypothetical example, the effect on performance of adding commodities to the portfolio was marginal; average returns improved by roughly 50 basis points. However, the potential impact on volatility was highly significant. Adding commodities to the all-equity portfolio increased the Sharpe ratio from 0.29 to 0.35. Another interesting comparison is 100% equity exposure versus 80% exposure to the 60% equity/40% bond portfolio and 20% commodity exposure. The returns of the two portfolios are comparable (equity portfolio returns are potentially higher by 11 basis points), while the diversified portfolio potentially has 41% less volatility. To further understand the fundamental source of diversification benefits of commodity futures, we compared the equity and commodity futures returns during different stages of the business cycle.

6 0% 10% 20% 30% 40% 50% 60% 70% 80% 90% 100% Percentage of portfolio in commodities 100% equities 60% equities/40% bonds

Notes: This hypothetical illustration does not represent the return on any particular investment. Corporate bond returns for this and subsequent figures in this paper are based on the following series: before 1968, Standard & Poors High Grade Corporate Index; 19691972, Citigroup High Grade Index; and January 1, 1973, through April 30, 2009, Barclays Capital U.S. Credit Bond Index. Sources: Vanguard calculations, based on Commodity Research Bureau; Datastream, Thomson Reuters.

Adding commodity futures can benefit during different stages of business cycle
It is also instructive to look at the relationship of commodity futures returns and equities over a typical business cycle. As identified by the National Bureau of Economic Research (NBER), the business cycle can be divided into four stages: late expansion, early recession, late recession, and early expansion. Figure 16 illustrates these patterns using the historical record. As shown in Figure 16, during late expansion and before the onset of recession, the equity market has tended to experience low returns, which continue during the early part of the recession. Further, because equities are a leading indicator of the business cycle, equity markets tend to recover before a recession is over; also, during the late-recession period, equities have typically

significant diversification gains could have resulted from adding commodities. For example, adding 10%20% commodities would potentially have reduced volatility in the 60%/40% portfolio by about 1 percentage point and almost twice that for the all-equity portfolio (see Figure 14).
Figure 15 reports the hypothetical impact of a 20% exposure to commodities on portfolio returns and volatility. The first two columns report total returns,

74% Did not opt

18% Partial opt-

8% Full opt-out

10-year excess returns 10-year excess returns 10-year excess returns 1-year excess returns: 1-year excess returns: 1-year excess returns:

16

Figure 15.

Effects on portfolio returns and Sharpe ratios of adding commodities to portfolio: August 31, 1959, through April 30, 2009 80% (60% equities/ 40% bonds)/ 20% commodities 8.94% 8.98% 0.40

100% equities Total return Standard deviation Sharpe ratio 9.05% 15.34% 0.29

60% equities/ 40% bonds 8.45% 10.46% 0.31

80% equities/ 20% commodities 9.51% 12.86% 0.35

Note: This hypothetical illustration does not represent the return on any particular investment. The first two columns report total returns, standard deviations, and Sharpe ratios for the all-equity and 60%/40% equity/bond portfolio. The next two columns report the same for these two portfolios after adding a 20% exposure to commodities.

Sources: Vanguard calculations, based on Commodity Research Bureau; Datastream, Thomson Reuters.

experienced higher returns. Commodities futures, however, have behaved very differently from equities over the course of the business cycle. Commodity futures returns are plausibly linked to the state of inventories in the economy,7 and their returns can therefore be expected to be a lagging indicator of recession. Thus, during the late-expansion period (anticipating a recession), while equity markets tend to experience relatively poor returns, low inventory levels would imply that commodity futures are experiencing higher-than-normal returns. Further, because of inertia in inventories, it is not until a recession sets in that commodities experience low returns. As stated, coming out of a recession, equities have tended to revive before the recession ends, while commodities futures returns have tended to improve only after the early expansion period has begun. To define early and late recession, we divided each of the eight recessions from 1959 through 2009 into two equal halves. For example, for the 2001 recession that lasted from April to November, we defined the period of April 2001 through July 2001 as early recession, and August 2001 through November 2001 as late recession. For the

current recession, we defined the first 12 months (January 2008 through December 2008) as early recession, and January 2009 through April 2009 as late recession. For the expansionary period, the 12 months before a recession were defined as late expansion, and the 12 months after a recession as early expansion.
Figure 16. Potential diversification benefits of integrating commodities with equities during different stages of business cycle

NBER Peak

Late expansion (High commodity returns, low equity returns)

Early recession

Late recession (Low commodity returns, high equity returns)

Early expansion

NBER Trough

Note: NBER, National Bureau of Economic Research. Source: Vanguard.

7 For details, see Gorton et al. (2008).

17

Figure 17.

Business cycle and diversification benefits of commodities Eight recessions since 1959 Equities Bonds 1.01% 3.03% 20.30% 8.64% Commodities 22.67% 4.48% 1.14% 5.48% Last three recessions, since 1990 Equities 5.40% 27.88% 14.62% 0.09% Bonds 7.84% 1.57% 9.41% 9.37% Commodities 10.74% 18.05% 14.74% 7.91%

Late expansion Early recession Late recession Early expansion

1.72% 25.04% 32.39% 13.68%

Note: This table reports equity and commodity futures returns during different stages of the business cycle. To define early and late recession, we divided each of the historical recessions into two equal halves. The 12-month period before a recession was defined as late expansion, and the 12-month period after a recession was defined as early expansion. All returns are average annualized returns. Sources: Vanguard calculations, based on Commodity Research Bureau; Datastream, Thomson Reuters.

Figure 17 reports equity and commodity futures returns during the different stages of the business cycle: We analyzed the eight recessions since 1959, and we also segregated the last three recessions (all three occurring after 1990). During the late-recession period, the average annual return for equities was 32.39%, while commodities declined 1.14%. During the late-expansion period, although equities had started their decline and experienced average annual returns of 1.72%, commodity futures markets were actually booming, with average annual returns of 22.67%. These results were robust, and the pattern persisted for the shorter period of three recessions since 1990, including the current recession. In the current recession, equities peaked in October 2007, before the start of the recession, and commodities peaked in June 2008, six months after the economy was in recession. For the period November 2007 to June 2008, the average monthly return for equities was 1.98%, while that for commodities was 3.11%.

Commodity futures returns and inflation

Inflation is a serious concern for investors who care about the real purchasing power of their returns. Given the relationship between commodity futures returns and the stages of the business cycle, it is instructive to explore the relationship between commodity returns and inflation. Many traditional asset classes are a poor hedge against inflation at least over short- and medium-term horizons. Figure 18, which reports the correlation of inflation with commodity futures, equities, and bond returns, suggests that commodity futures might be a slightly better inflation hedge than stocks or bonds. We calculated correlations at monthly as well as rolling quarterly and annual horizons.

Figure 18.

Correlation of equities, bonds, and commodity return series with inflation: August 31, 1959, through April 30, 2009 Equities Bonds 0.10 0.14 0.25 Commodities 0.08 0.25 0.34

The results of this section suggest that commodities can have diversification benefits because commodities behave fundamentally differently than equities at different stages of the business cycle. Note, however, that this analysis can only become clear in hindsight. Predicting periods of outperformance or underperformance for any asset class can be extremely difficult, if not impossible.

Monthly frequency Quarterly frequency Annual frequency

0.09 0.05 0.10

Sources: Vanguard calculations, based on Commodity Research Bureau; Datastream, Thomson Reuters.

18

Although it appears that commodity futures come out in front of equities and bonds as an inflation hedge, the asset class is not a perfect hedge for inflation. To the extent that commodity futures represent a bet on commodity prices, they are directly linked to the fundamental components of inflation. However, they do not provide a hedge against certain other components of inflation, such as increasing health cost. Further, because futures prices include information about foreseeable trends in commodity prices, commodity futures returns are likely to rise and fall with unexpected components of inflation. A detailed analysis of the relationship of commodity futures returns to inflation is beyond the scope of this paper, and is a subject of future research. If the investors primary objective is to obtain an inflation hedge, then, clearly, TIPS (Treasury Inflation Protected Securities) would be a much better option.

relationship to the business cycle will change. This would suggest that future corrections between equities and commodity futures could remain relatively low, offering potential diversification benefits to investors who are willing to accept the unique risks and opportunities of this asset class.

References
Bodie, Zvi, and Victor Rosansky, 1980. Risk and Return in Commodity Futures. Financial Analysts Journal (May/June): 2739. Davis, Joseph H., and Roger Aliaga-Daz, 2009. The Global Recession and International Investing. Valley Forge, Pa.: Vanguard Investment Counseling & Research, The Vanguard Group. Fama, Eugene F., and Kenneth R. French, 1987. Commodity Futures Prices: Some Evidence on Forecast Power, Premiums, and the Theory of Storage. Journal of Business 60: 5573. Gorton, Gary, and K. Geert Rouwenhorst, 2006. Facts and Fantasies about Commodity Futures. Financial Analysts Journal 62(2): 4768. Gorton, Gary, Fumio Hayashi, and K. Geert Rouwenhorst, 2008. The Fundamentals of Commodity Futures Returns. Yale ICF Working Paper No. 07-08. New Haven, Conn.: Yale University. Hicks, John R., 1939. Value and Capital. Oxford: Oxford University Press. Keynes, John M., 1930. A Treatise on Money, vol. 2. London: Macmillan Publishers. Santos, Joseph, 2008. A History of Futures Trading in the United States. In EH.Net Encyclopedia of Economic and Business History, edited by Robert Whaples, March 16; available at http://eh.net/ encyclopedia/article/Santos.futures. Working, Holbrook, 1960. Speculation on Hedging Markets. Food Research Institute Studies 1: 185220.

Conclusion
This paper has addressed the attractiveness of a broadly diversified portfolio of commodity futures as an asset class. It is critical to understand that an investment in commodity futures does not represent direct exposure to physical commodities. Commodities futures prices are set in relation to expected spot prices at maturity, and not to current spot prices. A historical analysis of commodities futures return patterns suggests there is little merit in the argument that relatively high long-term average commodities futures returns are solely a result of a few brief abnormal periods of high returns. Commodities futures have experienced long periods of significant returns for investors, as well as sequences of booms and busts similar to equities. Historically, commodity futures returns and equity returns have had very low correlation, and although this correlation has risen over time, recent data suggest the correlation between equities and commodities futures is lower than that between equities and other broadly accepted diversifiers, such as international equity. In addition, while equities are leading indicators of the business cycle, commodity futures have tended to be lagging indicators. There is no reason to expect that this

19

Appendix. Construction and methodology of the commodities return series

We followed the methodology of Gorton and Rouwenhorst (2006) in constructing our equally weighted commodities return series. The steps in constructing the return series were: 1. For each month, we constructed price returns on each commodity future using the nearest contract not expiring in that month. 2. For a mechanical trading strategy, on the last business day of the month before the expiration date of a futures contract, we rolled the contract into the next nearest futures contract. 3. Using monthly returns for each commodity futures contract, we constructed the return series by adding the monthly returns together for each month and then dividing them by the number of commodities in the return series for that month. Thus, we essentially have an equally weighted indexing approach with monthly rebalancing. 4. A commodity enters the return series on the last business day of the month following its introduction date. 5. Finally, to obtain the total returns of holding a fully collateralized commodity futures position, we added to the price returns the 3-month U.S. Treasury bill return.8
Selection of commodities The list of 30 commodities that were selected for this study is based on most of the 23 commodities eligible for inclusion in the DJ-UBS Commodity Index (DJ-UBSCI). We augmented this list with nine more commodities: coal, feeder cattle, lumber, oats, orange juice, palladium, propane, rough rice, and soybean meal. Also, because of data limitations, we did not include tin and lead; 9 tin and lead are part of the eligible commodities, but are not in the final list of 19 commodities currently in the DJ-UBSCI.

Figure A-1.

Commodity futures returns: Summary statistics (August 31, 1959, through April 30, 2009) Commodities universe DJ-UBSCI: DJ-UBSCI: 19 current 21 eligible commodities commodities* All 30 commodities in our return series 9.85% 12.79% 0.38 0.13

Total returns Volatility Sharpe ratio Correlation with equities

10.52% 13.84% 0.40 0.11

10.23% 13.58% 0.39 0.12

*Does not include tin and lead (for explanation, see Appendix text). Sources: Vanguard calculations, based on Commodity Research Bureau; Datastream, Thomson Reuters.

The reason we included the additional nine commodities was to broaden our commodities universe. Some of the commodities, like oats and soybean meal, have long trading histories going back to 1959. These additional nine commodities represent broad sectors of the commodities universe: energy (coal and propane), grains (oats, soybean meal, and rough rice), softs (orange juice), industrial materials (lumber), animal products (feeder cattle), and precious metals (palladium). To test the impact of membership of these 30 commodities in our commodities return series, we constructed three series of returns, using the five steps just described. The first series is based on the 19 commodities currently in the DJ-UBSCI. The second series is based on just the 21 commodities (not including tin and lead) eligible for inclusion in the DJ-UBSCI. The third series represents our broad-based commodities return series, which includes all 30 commodities listed in the text in Figure 3. Figure A-1 cites the total

8 Source: http://research.stlouisfed.org/fred2/. 9 These commodities are traded on the London Metal Exchange, and their data are not covered by the Commodity Research Bureau, our primary data source.

20

returns, volatility, Sharpe ratios, and correlation with equities for the three commodity return series from August 31, 1959, through April 30, 2009. The results were very similar for all three measures. The volatility of our commodities return series, however, was the lowest, because of the impact of greater diversification. Given this papers objective to study the behavior of commodities as a broad asset class, we thus favored the equally weighted return series based on all 30 commodities.
Why equally weighted returns? Since our commodities return series is an equally weighted average of individual commodity returns, it is well-diversified and represents the broad commodities market. Given equal weights, no one single commodity or sector can drive the results. However, one can still question whether the results of our analysis are conditional on the commodities return series. Recall the two components of our return series construction: equal weighting and monthly rebalancing (an outcome of the equally weighted average). Gorton and Rouwenhorst (2006) have shown that returns and volatility properties of commodity futures are robust to annual rebalancing as well. An alternative to equal weighting would be a weighting scheme such as that adopted by the DJ-UBSCI, whose weights are based on the production volume and/ or liquidity of individual commodities. Serious data restrictions apply, however, in constructing such an index; further, such backfill could arguably amount to or lead to a data-mining effort; the agnostic, equally weighted approach has the virtue of simplicity and transparency. Later in this Appendix we nonetheless compare our commodities return series with both the DJ-UBSCI and the S&P-GSCI over the time period common to all three.

Investability Could an investor have actually earned the returns shown by our return series? Like other indexes, the equally weighted return series results do not reflect any transaction costs, which would apply in the real world. However, clearly, commodity futures markets historically have had the depth that an investable strategy requires. As documented by Santos (2008) and numerous others, the commodities markets in the United States have a long history, with trading in agricultural commodities voluminous even in the 19th century. Santos reported that between 1884 and 1888, the volume of grain (wheat, corn, oats, barley, and rye) futures traded in the U.S. market was eight times the average annual amount of crops produced. For cotton, by 1879 futures volume had outnumbered production by a factor of five. Working (1960) estimated that for the period 19541958, the average dollar value of short hedging contracts for cotton, wheat, soybean, corn, and soybean oil was close to $500 million. Certainly a relatively small investor could have bought the contracts listed and analyzed in our commodities return series and endeavored to replicate the equal weighted methodology. But as with historical analysis of any asset class (e.g., stocks, bonds, or short-term debt), it is difficult, if not impossible, to know how the hypothetical development of a large, liquid, and institutionally dominated market would have affected past returns. Comparing commodities return series with DJ-UBSCI and S&P-GSCI DJ-UBSCI data are available from 1991, and the index itself was launched in 1998. S&P-GSCI data are available from 1970, and the index was launched in 1992. This section compares the performance of these two indexes with our equally weighted commodities return series on a number of parameters over the period common to all three

21

Figure A-2.

Commodities return series, DJ-UBSCI, and S&P-GSCI: Correlation with domestic equities, inflation, and bonds (January 31, 1991, through April 30, 2009) Commodities return series 0.91 0.75

Domestic equities Commodities return series DJ-UBSCI S&P-GSCI 0.28 0.23 0.17

Inflation 0.22 0.23 0.28

Bonds 0.16 0.16 0.11

Sources: Vanguard calculations, based on Commodity Research Bureau; Datastream, Thomson Reuters.

measures: January 31, 1991, through April 30, 2009. For this period the DJ-UBSCI and the commodities return series had a high correlation of 0.91 at monthly frequency; the correlation with the S&P-GSCI was much lower, at 0.75 (see Figure A-2 ). As the figure shows, the commodities return series had a marginally higher correlation with domestic equities than did the DJ-UBSCI. In terms of inflation and bond returns, the DJ-UBSCI was correlated almost exactly (inflation) or exactly (bond returns) with the commodities return series. The DJ-UBSCI is well recognized as a broad-based commodities index, while the weighting structure of the S&P-GSCI makes it primarily an energy index. As of April 30, 2009, the energy subsector weighting in the S&P-GSCI was more then 70%, whereas the energy sector weighting in the DJ-UBSCI is capped at 33%. The DJ-UBSCIs greater diversification makes it much less volatile than the S&P-GSCI. However, as shown in Figure A-3, the commodities return series is clearly the least volatile of the three measures; this is to be expected, given the equally weighted nature of the return series and the embedded diversification benefits. Figure A-4 plots the cumulative returns of the three measures.
Composition of commodities return series The composition of the commodities return series as constructed here changed significantly from the 1960s to the 1990s as different contracts were

Figure A-3.

Commodities return series, DJ-UBSCI, and S&P-GSCI: Summary statistics (January 31, 1991, through April 30, 2009) Commodities return series

DJ-UBSCI 0.44% 0.17% 0.66 3.16

S&P-GSCI 0.36% 0.37% 0.46 1.88

Average Variance Skewness Kurtosis

0.51% 0.11% 0.95 5.65

Sources: Vanguard calculations, based on Commodity Research Bureau; Datastream, Thomson Reuters.

added to the return series. For example, for the first subperiod identified in this paper (19591971), there were no energy futures contracts. It is possible that the historical return and diversification properties of the return series are distorted owing to its composition. To address the issue of composition, we considered three subperiods (see Figure A-5 ). During the first subperiod (1959 through 1971), commodities in the return series were cocoa, copper, corn, cotton, oats, soybean meal, soybean oil, soybeans, wheat, sugar, silver, live cattle, lean hogs, orange juice, platinum, and lumber. These commodities represented the following sectors: softs, grains, industrial metals, industrial materials, animal products, and precious

22

Figure A-4. Commodities return series, DJ-UBSCI, and S&P-GSCI: Cumulative returns (January 31, 1991, through April 30, 2009)

Cumulative returns 600 500 400 300 200 100 0 1990 1992 1994 1996 1998 Year Commodities return series DJ-UBSCI S&P-GSCI 2000 2002 2004 2006 2008

Sources: Vanguard calculations, based on Commodity Research Bureau; Datastream, Thomson Reuters.

Figure A-5.

Total returns (volatility) for equities, inflation, bonds, and commodities return series: Subperiod analysis Commodities return series (%) 7.74 (8.68) 8.08 (12.45) 6.86 (11.53)
Did not opt out Partial opt-out Full opt-out

Equities (%) 19591971 1975April 30, 2009 1988April 30, 2009 8.02 (12.92) 11.45 (15.84) 8.57 (15.03)

Inflation (%) 2.81 (0.7) 4.19 (1.14) 2.90 (0.93)

Bonds (%) 3.52 (5.38) 8.66 (7.3) 7.35 (5.28)

Sources: Vanguard calculations, based on Commodity Research Bureau; Datastream, Thomson Reuters.

metals. Notable exceptions were gold and energy products, both of which were introduced in the second subperiod, 1975 through April 30, 2009; natural gas was added in 1990, and coal in 2001. The last subperiod, 1988 through April 30, 2009, included almost all of the energy contracts as well.

For the first subperiod, 1959 through 1971, the commodities return series had no energy or gold Europe 10-year excess returns: futures contracts; yet, it produced a return of 7.74% 10-year excess returns: U.S. 10-year excess returns: Global with a volatility of 8.68%; this was nearly equal to 1-year excess returns: Europe the 8.02% return of equities, which had a volatility 1-year excess returns: U.S. of 12.92%. The higher volatility of the second and 1-year excess returns: Global third subperiods has not just been a characteristic of commodities, however; all the asset classes have had higher volatility.

23

P.O. Box 2900 Valley Forge, PA 19482-2900

Connect with Vanguard > www.vanguard.com > global.vanguard.com (non-U.S. investors)

Vanguard research > Vanguard Center for Retirement Research Vanguard Investment Counseling & Research Vanguard Investment Strategy Group E-mail > research@vanguard.com
The funds or securities referred to herein are not sponsored, endorsed, or promoted by MSCI, and MSCI bears no liability with respect to any such funds or securities. For any such funds or securities, the prospectus or the Statement of Additional Information contains a more detailed description of the limited relationship MSCI has with The Vanguard Group and any related funds. Standard & Poors , S&P , and Standard & Poors 500 are trademarks of The McGraw-Hill Companies, Inc., and have been licensed for use by The Vanguard Group, Inc. Vanguard mutual funds are not sponsored, endorsed, sold, or promoted by Standard & Poors, and Standard & Poors makes no representation regarding the advisability of investing in the funds.

2010 The Vanguard Group, Inc. All rights reserved.

For Institutional Investor Use Only. Not for Public Distribution.

ICRMR 032010