Portfolio managers, depending on the manager and type of investment firm, usually advise investors to allocate anywhere from 5% to 20% of their portfolios to commodities. The reason is simple: commodities provide diversification. Over time, diversification should improve returns and lower risk.
Diversifying among different commodities, each with its own supply and demand factors, may reduce the volatility of a portfolio and return it to safer risk levels. Unleveraged, commodities have historical volatility well below that of small-cap U.S. stocks and even stocks of emerging markets. Several other reasons exist in favor of diversification into commodities. First, commodities reduce exposure to inflation. Second, commodities have low correlations to stocks and bonds, so they’re good diversifiers for traditional portfolios of financial securities.
While commodities carry risk, they are not intrinsically risky. Leverage is what makes them appear so, but the good thing about leverage is it’s up to the investor how much to exploit it. The bottom line is that if an investment is made appropriately in a commodity, risk may be reduced.
Investors can gain exposure to commodities through a managed fund, an advisor-managed account or commodity related mutual funds. An avenue growing in popularity is broad-based commodity indexes, such as one of the five commodity indexes with exchange-listed contracts: the Goldman Sachs Commodity Index, the Dow Jones-AIG Commodity Index, the Rogers International Commodity Index, the Deutsche Bank Liquid Commodity Index and the Reuters/Jefferies Commodity Research Bureau Index.
Yet another approach is simply direct exposure to commodity vehicles, such as commodity futures. Indeed, this offers you the most flexible exposure to these markets. It allows you to take full advantage of the benefits of diversification because you can directly manage your positions within the commodity segment.
Any mixture of commodities should not just seek to balance positions in financial or equity markets. The commodities themselves also should be uncorrelated to each other.
If the commodities are correlated, they will not be particularly useful for mainstream portfolio diversification. If there is high correlation between a potential market and the existing portfolio, then adding the new market will not help in diversifying the overall exposure. Of particular importance is the correlation to the financials because this would actually decrease the effectiveness of the commodity portion of the portfolio.
One problem diversified managers run into is a lack of capacity in liquid commodity markets to balance large allocations in financial markets. Most managers run out of commodities to trade before they reach the optimal mix.
One commodity that is particularly uncorrelated to most, and could solve this dilemma but is often overlooked, is milk. Milk futures are traded at the Chicago Mercantile Exchange. Class III milk futures, the most liquid contract in the complex, will help diversify the commodity section of a portfolio and potentially reduce overall portfolio risk (see “Spreading risk,” below).
As shown in “Taking stock of milk” (below), S&P and Class III milk futures are not interrelated at a micro level, so diversification mitigates individual-sector risk. In other words, a slump in the economy might affect the S&P 500, but a lesser effect on Class III milk prices would allow the overall portfolio to weather the storm.
Overall, the nine markets shown in “Spreading risk” show weak correlation to the Class III milk market throughout the period 2000-05. This is good news for milk as a potential addition to the commodity portion of a portfolio, because it should not follow any trend exhibited in the markets that represents existing positions.
A common measurement of correlation is r-squared. In basic terms, this statistic represents how much the change in one variable, or market, explains the changes in a second variable — all else equal. The low r-squared value of the relationships indicates the weakness of the link between Class III milk futures and the nine selected markets. For example, the extremely low r-squared value for milk futures and the S&P 500 suggests they effectively move independently through this time horizon; the changes in neither one explain the changes in the other.
Even if you took the highest five-year average correlation for all selected markets of 0.45 for the euro currency and feeder cattle, this yields an r-square value of 20.1%. Thus, on average, moves in Class III milk have been 20.1% explainable by the daily activity of the euro and feeder cattle markets. This is still not high at all, as prices can either go up or down and with any r-square under 50%, we may as well be flipping a coin to define a useable trading relationship. In other words, statistics suggest that Class III milk and the nine selected markets listed are not highly correlated.
Admittedly, however, the tale is a bit different when the study is narrowed to individual years. In these selected shorter time frames, individual correlations rise rather dramatically. In 2002, the S&P showed a 0.83 correlation to Class III milk. Coffee showed a 0.81 correlation to Class III milk in 2005, and corn showed a 0.81 correlation to Class III milk in 2004.
The 0.83 and 0.81 correlations in these years yield a fairly high r-square too, 69% and 66% respectively. That means that nearly 70% of the price changes in Class III milk were explained by the concurrent movements in the S&P 500 in 2002, coffee in 2005 and the corn market in 2004.
These highly correlated years of Class III milk and the nine selected markets may have negatively affected portfolios if positions were held in the years that they turned downward.
That should help drive home the point that diversification is a long-term process. The five-year average correlation clearly demonstrates Class III milk is a proven diversifier for long-term investors. As we have seen many times, typically correlated markets can move opposite of one another for brief periods. Likewise, typically uncorrelated markets can move together at times. This is one fact of investing that can’t be escaped.
NEW ERA, NEW RULES
Investing used to be easier. Stocks performed differently than bonds, and foreign stocks differently than domestic ones. Managers who grew too large to use agricultural commodities as a diversifier could always turn to non-U.S. stock indexes and interest rate markets. With the onset of the E.U. and globalization, financial markets have become more correlated and the need for commodities as a diversifier — and more diverse commodities to trade — has grown. Class III milk is one commodity still weakly correlated to stocks, bonds and other commodities and is one of the few remaining tools for portfolio diversification.
Successful investing is about reducing risk. If you mix it up by adding commodities to the traditional stock and bond portfolio, you smooth out the bumps. More so, within your portfolio’s commodity portion, you need to be careful. Crude oil and metals are not enough.
Class III milk futures are a valid addition to any portfolio, not just in terms of outright opportunity, but in the risk/reward benefits they offer to the typical approach to asset allocation.
Chris Lindborg is an economist with Downes-O’Neill LLC and eDairy. E-mail him at firstname.lastname@example.org or visit the Web sites www.downesoneill.com or www.edairy.nu.