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 November 2011 The Problem with Commodity Diversification Why Commodities Don't Act as Expected
It's only natural for investors to look elsewhere for diversification. Currently, many are turning to commodities. Livestock, agricultural products, and precious and industrial metals are vastly different than equities or traditional fixed income. Their trading patterns bear little correlation to those of more common investments. At least that's the commodity bulls' argument, although the facts often suggest otherwise. That's why investors are frequently disappointed when their commodity investments don't act as expected. The answer may have something to do with the new means of commodity investment. It used to be the only way to participate in the market was to trade commodity futures. That's changed with the advent of exchange traded funds (ETFs) and exchange traded notes (ETNs). These pooled investment vehicles trade like stocks and can be parts of traditional "long" brokerage accounts. This opens up the market to retail investors who wouldn't think of trading futures or handling a margin account. Could ETFs, ETNs, and their benchmark indexes explain why so many investors are seduced and abandoned by commodities? Why would this be the case anyway? What is it about commodities that leads investors to think they'll behave in one manner only to later find they don't? Why does their promise of additional diversification generally go unfulfilled? Is this an issue for commodities or commodities investors? Let's take a look at both.
Not All Indexes are Created Equal
Commodities fall into four major categories: Energy, agricultural products, precious metals, and industrial metals. Popular commodity indexes -- such as the CRB Index or the Dow Jones UBS Commodities Index -- include all four categories in order to cover the entire market. What differs between them is the weights they place on each category. This is meaningful because it impacts the indexes' risk, return, and ultimately, investors' results. To see how this happens, consider the five commodity indexes shown on Chart 1. The second and third columns show the names and weights of five well-known commodity indexes. Three of the five focus on Energy while the remaining to emphasize Agricultural products. On the other end of the spectrum, four of the five give the lowest weight to Precious Metals. So far this year, Energy has been the top performing type of commodity, Livestock the worst. Why does this matter? Take a look at the final two columns in Chart 1. Returns for the first nine months of 2011 range from a low of -13.62% to -5.18% while standard deviations (a common measure of risk) range from 21.21% to 16.72%. To a great extent, these differences are reflective of index's individual compositions. The best performers (DB and S&P GSCI) have the greatest differences between the Energy overweight and the Precious Metals underweight(45% and 41%, respectively). On the other hand, the poorest performers (Rogers and DJ/UBS) give Precious Metals a stronger role and Energy much less.
This is more than simply an issue of short-term return, it has consequences for long-term planning as well. When seeking to increase diversification, investors are likely to add commodity indexes to traditional asset classes when creating portfolio asset allocations. As Chart 2 illustrates, the addition of some commodity indexes has a positive impact over those using only traditional assets while others don't. The red line is the efficient frontier using only traditional asset classes. Each of the white lines represents a frontier created by mixing one of the five commodity indexes with the traditional asset classes. All frontiers are based on data from the common period September 1998 through September 2011. It's pretty obvious from Chart 2 that contrary to popular belief, simply adding commodities to an asset allocation model does not necessarily improve return or control risk. Only one of the four frontiers including a commodity index is superior to that with only traditional asset classes. In the other instances, portfolios were actually less efficient at all levels of risk. So much for the additional diversification of commodities. The other thing that's clear is that the commodity index used in the allocation model has a definite impact on the resulting portfolios. Investors should realize this and put a lot of effort into selecting the proper index. The only question remaining is how to define it. Then again as you'll see below, this may be giving too much credit to the broad indexes.
Less Diversification Than You Think But take a look at Chart 3 which shows the 5-year rolling correlation of the S&P 500 to the other traditional asset classes as well as the five commodity indexes. The first thing to notice is the close correlation of all five commodity indexes are with the S&P 500. Although their compositions differ, they all have similar correlations with the broad equity index. This suggests the choice of commodity index used in the asset allocation process may not be as critical as Chart 2 may make it appear.
On the other hand, adding a commodity index may not have as much impact on the model as one might first think. From Chart 3, the S&P 500 has considerably less correlation with the bond series than the commodity series. In other words, adding bonds and/or cash to a portfolio may yield greater diversification than the addition of commodities. Stuffy old bonds and bills may not be as sexy as gold futures or pork bellies, but the former may still provide greater diversification. This, by the way, supports the earlier findings. But that's not all. If investors are truly seeking diversification in their portfolios, the broad commodity indexes may not be the best source. Instead, their individual components may provide better results. This is illustrated on Chart 4.
Unlike Chart 3 which shows the correlation of the S&P 500 to traditional asset classes and the commodity indexes, Chart 4 shows the rolling five-year correlation of the well-known CRB Commodity Index with other asset classes including its components, represented by the dotted lines. Interestingly, the broad CRB index has lower correlations with some of its individual components than with other traditional asset classes. This suggests investors seeking diversification (hence low correlation between asset classes) would be better off adding some of the individual index components rather than the indexes themselves. In the past it would have been difficult to put this finding into practice, but now virtually every component area of the commodity market can be purchased in an ETF. Not only that, the rush to create a meaningful niche in the ever growing ETF market is pushing management firms to bring more alternatives to market almost every day. If you don't like the options available today, check back tomorrow.
Avoiding User Error Second, it's important to understand the benchmarks used to create asset allocation models and measure performance. As Chart 2 so clearly demonstrates, the commodity benchmark selected can have a major impact on the resultant efficient frontier and asset allocation models along it. It's also critical to understand the composition of the index in order to focus on other potential holdings with lower correlation and greater diversification potential. Third, as suggested by Chart 4, superior diversification is more likely if the investor considers actual correlations rather than the depth of the market section it represents. That's why a precious metals or energy ETF may offer greater diversification than a broad based index ETF. Expenses may be higher on the latter, but thanks to its lower correlation, specific commodity segment ETFs my be the better alternative. Finally, it's not evident that commodities are essential to proper diversification. As Charts 3 and 4 suggest, there is greater diversification potential with stocks with traditional asset classes such as bonds and Treasury Bills. There's no need to look elsewhere if traditional asset classes can serve the purpose. Expenses would be lower, too. As a result, it's not obvious commodities belong in every investor's portfolio. Anyone using them should fully understand concepts such as "backwadation" "contango", "roll premium", and a number of other concepts that determine commodity pricing and performance. Although it's now much easier to acquire exposure to commodities via ETFs and ETNs, it's still not necessary. Search this site! Just enter you key word or words:
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UST TEN OR FIFTEEN YEARS AGO investors were debating the value of adding international stocks to their portfolios. Advocates' argued the addition of foreign stocks would increase the benefits of diversification. They often pointed to the fact correlations were lower between U.S. and foreign equities than among various styles of purely domestic equities. Now, as we pointed out 
