Investors would prefer not to sacrifice returns to lessen risk through asset diversification and so they look for uncorrelated assets with a positive return. That is why many have come to invest in tangible commodities. Tangible commodities belong in any portfolio devoted to maximizing return while minimizing risk.
THE DRUNK IN A FIELD
Back in 1900, the French mathematician Louis Bachelier identified how much someone could win or lose while trading if there was an equal probability of price changes up and down, and how soon such gains or losses would occur. He based his ideas on the principles of heat diffusion described nearly a century earlier by Joseph Fourier. In 1905 two English scientists, Karl Pearson and Lord Rayleigh, discussed the concept of what soon thereafter came to be known as a “random walk,” with Pearson noting, “In an open country the most probable place to find a drunken man who is at all capable of keeping on his feet is somewhere near his starting point.”
Bachelier’s work can be used to determine how long it will take such a drunken man to wander off the field onto the surrounding superhighway where he can be hit by a truck. The smaller each individual step is, the closer he will be to where you left him. The bigger his steps and the longer you leave him, the greater the chance he will wander into danger. Lowering volatility makes each step forward and backward smaller. Analogously, if your total portfolio moves up and down in smaller steps, it is likely to last longer — long enough, hopefully, to let its basic positive return emerge before it is hit by the truck of chance.
The best way to lower a portfolio’s volatility is to add uncorrelated assets to it. A 50/50 mix of two uncorrelated assets, both of which have an ultimately positive return, will not only have a positive return but a far smoother one as well and thus a higher Sharpe ratio.
This is the secret of diversification: that returns of a portfolio consisting of numerous uncorrelated assets will be cushioned when one falls while the others rise or stay the same. That is why old-timers say that diversification is the only free lunch in investing.
For this reason, and because the choice of asset class has a greater effect on returns than the choice of any particular member of that class — and is indeed responsible for as much as 90% of returns — many investors and portfolio managers focus on choosing the type and percentage of asset classes rather than on specific stocks, bonds or commodities. In fact, adherents to the capital asset pricing model believe that transaction costs would make selecting individual assets inefficient compared to using an index.
Academic interest in portfolio construction, diversification and managing risk advanced along with the speed of computers in the 1970’s, resulting in a good understanding of asset allocation as applied to stocks and bonds, but not to commodities. Investors have traditionally owned stocks for appreciation and bonds for stability, but the idea of having commodities in an investment portfolio is relatively new. Only gold has had a long history as an investment. Other tangible commodities such as cattle, copper and cotton were not considered for investment purposes until the past 15 years or so.
Before that, theoreticians, investment institutions and their advisors knew little about tangible commodities — and the little that they thought they knew was that commodities were far more volatile than stocks and that most commodity investors went broke. It was probably true that most commodity investors lost money, but this was not due to any inherent danger. It was because commodity futures can be bought on so little margin, as low as 5%, that even small price changes lead to large fluctuations in profit and loss; and it is this observation that has led people to believe that the dollar values of the commodities themselves were very volatile. This is not true.
When theoreticians actually measured commodity price volatility, they found that commodities were less volatile than equities. This fact, coupled with commodities’ lack of correlation with equities and with bonds, prompted theoreticians to look at them as a unique asset class that could provide substantial diversification when added to an investment portfolio.
Traditionally, the commodity market was composed of “hedgers” who used the market to establish prices for commercial reasons and “speculators” who tried to profit from price movement. As a result of the application of asset allocation principles to commodities, we have seen the development of a third major market participant: the commodity investor. Unlike the speculator who makes his or her own buy and sell decisions or is guided to them by his broker, the commodity investor typically employs a third party fund manager to make the decisions. As a consequence of the rise in energy and metals prices, the prospect for further increases due to the long-term economic growth of the developing Chinese and Indian economies and of the fear of U.S. inflation, more and more people, and institutions, are now investing in commodities. Many of them have come to include a diversified basket of tangible commodities in their portfolios. The pool of such investments is today thought to be well over $100 billion.
COMMODITIES IN THE MIX
When I sold my commodities businesses, first Mocatta, the world’s largest gold and silver bullion dealer (now Scotia Capital), and later Brody White, a futures brokerage company (now Fimat) I established a family office to manage my investment portfolio. My fear of losing money led me first to study asset allocation, and then in 1987 to implement the diversification strategy to which that fear gave rise. To ensure the highest possible return/risk strategy, I built a portfolio diversified among several asset classes: stocks, bonds, currencies, real estate and commodities.
My optimization calculations mandated a 15% to 20% allocation to commodities. That allocation has been managed consistently and continuously by my firm from January 1987 to the present through a transparent, rules-based, long-only, diversified, multi-commodity portfolio as a distinct part of my overall investment portfolio. In January 2005 this strategy — Tangible Asset Program (TAP®) — was made available to qualified outside investors through investment banks and separate managed accounts.
The TAP methodology was developed without reference to prior models, for in 1987 there were no long-only diversified commodity indices or funds available. Although it was developed for diversification purposes, to lower risk and to smooth returns, TAP
has done quite well in terms of absolute returns.
The TAP methodology consists of a set of rules for choosing the commodities and the amounts of each one, which are updated annually. The current composition of TAP is shown in “Diversification” (below).
To make it possible to buy and sell the commodities without being subject to high transaction costs, our universe is limited to exchange-traded commodity futures contracts. We calculate the dollar value traded of all futures contracts as a measure of liquidity and average that number with double the global production value of the underlying commodities, reflecting that real commodity prices are determined in the streets and stores and not on exchange floors.
We then select the top commodities in each of six separate groups; the weight of each commodity and of each group is limited to ensure that the portfolio is truly diversified and not just a tail being wagged by some dominant commodity’s dog. Finally, each commodity’s weight is rebalanced whenever the initial weighting gets out of line. Rebalancing has had a beneficial effect in reducing the portfolio’s volatility.
Since defining the TAP methodology, interest has grown in using tangible commodities for diversifying an investment portfolio, as evidenced by the later creation of the GSCI and DJ-AIG commodity indexes. While the returns of these indexes have been similar, they are impacted by a problem to which TAP is not subject called roll-date congestion, the logical attempt by market participants to take advantage of the size of index funds.
THE BENEFITS
We found that it makes sense to put commodities into an investment portfolio because:
• Their historical returns and volatilities are similar to those of equities.
• Their returns are not correlated with those of equities or of bonds.
• Through most long periods since good price records have been available, commodities improve the risk/return profile of most “equities plus bonds” mixes to which they are added.
• They provide protection against political crises and natural disasters.
• They provide significant protection against inflation.
The 20-year history of TAP has resulted in returns that are comparable to that of equities. TAP’s commodities have, up to the date of this writing, provided a return of more than 12%; the S&P 500 is just under 11.5%. More important, commodities had a lower standard deviation, 12.5% compared to 15% for equities — despite the fact that there are more than 25 times as many items in the S&P 500 index as in the commodities portfolio. The higher return and lower volatility significantly enhanced TAP’s risk-adjusted return. TAP’s Sharpe Ratio, a measure of return/risk utility, was 0.58 — about as high as the Sharpe Ratio of bonds — and significantly higher than the 0.44 Sharpe Ratio of equities through the same period (see “More return, less risk,” below).
NON-CORRELATION
Commodity returns are not correlated with those of other asset classes. Indeed, they have had a slightly negative correlation with U.S. equities (-0.18), foreign equities (-0.11) and U.S. bonds (-0.13). The lack of correlation between asset classes that have positive returns reduces volatility (standard deviation) of returns and produces improved risk adjusted returns. Commodities’ lack of correlation with equities and bonds also confers downside protection during events that have a negative impact on stock and bond returns: events such as natural disasters, geopolitical uncertainty or times of increasing energy prices.
The low correlation of commodities with equities can be explained by thinking of equities as anticipatory assets. Investors value them based on their future cash flows. Commodities, on the other hand, are priced based on supply and demand; their prices reflect an equilibrium based on production and consumption rates and the adequacy of inventories. Where current inventory and future production appear inadequate to meet current and future needs, current prices rise to balance supply and demand and to induce producers to expand future production.
Commodities can be a source of return across market cycles. They have historically achieved positive returns not only when stocks and bonds heat up, but also when they went down.
There’s a sound economic reason for the counter-cyclical character of stock prices and commodity prices. Equity returns will be highest at the start of an economic expansion when expectations of future cash flows are running high, whereas commodity returns are highest near the end of an economic expansion when consumption rates are high, inventories are depleted and new production has not yet come on stream.
From 1987 onward, an allocation to a diversified basket of long-only tangible commodities has helped to increase a portfolio’s total return while decreasing its risk — even if, to buy commodities you had to lower your equity allocations in the ever-rising equity market of the past 20 years.
If we look at portfolios consisting only of domestic equities and domestic bonds, we can see that through the last 19 years adding commodities in various amounts improved the return/risk profile (see “A better mix,” below). In fact, each incremental addition of commodities to the original equity-bond mix defines a more favorable efficient frontier, with the largest addition of commodities (16%) resulting in the greatest hypothetical improvement.
The risk of an extreme loss is also reduced. While return, volatility and Sharpe Ratio are the most typical portfolio measures we use to compare portfolios, we also use an additional long-term risk measure called Decimal One over Ten, or DOT, (for 0.1%/10 years). It measures the lowest level, expressed in cents, to which one dollar’s worth of an investment could fall in the next
10 years with 99.9% confidence; that is, with less than a 1-in-1000 chance of happening. Since 1960, commodities have had a DOT value of 54, a higher level than that for equities, which is 45. Basically, this says two things: that there is a 1-in-1000 chance that in 10 years the value of a 100% equities portfolio could decrease to as low as 45¢ per dollar invested and that the most extreme hypothetical drawdown in commodities is likely to be smaller than that for equities.
PROTECTION FROM UNCERTAINTY
Commodities protect overall portfolio returns because they have shown little or no correlation to the downward moves of stock and bond markets and tend to gain in value during events that have a negative impact on stock and bond returns, but also protect a portfolio during political crisis and natural calamities.
In these periods the correlations of most financial assets, — with the possible exception of U.S. Treasury securities — tend to increase. Commodities, on the other hand, offer protection against losses during such times. In addition, large moves in commodity prices are more often up than down. These relationships are so well known that it is sometimes said that commodities “fall up.” Unlike equities and bonds, which are negatively correlated with the U.S. Consumer Price Index (CPI), commodities are positively correlated with the CPI (0.44). This is not surprising because commodity prices are a main determinant of the cost of living and thus of inflation.
HOW TO GET COMMODITY EXPOSURE
What is the best way to get diversified commodity exposure for your portfolio? Buying a collection of physical commodities is impractical for most investors because of the difficulties of purchase, transportation, storage, spoilage and shrinkage and the inability to rebalance.
There are only four practical ways to go about obtaining it: natural resource shares; managed futures funds; non-diversified commodity sector funds; diversified commodity funds and indices, but most of these are not efficient.
Some people seek commodity exposure through natural resource stocks. This does not work, for the value of such stocks is affected by industry competition, management’s successful strategy execution and production-related hedging, all of which affect performance. There is often little correlation between the prices of a commodity producer’s shares and the commodity itself.
Others hope to obtain it by buying a managed futures (or commodity trading advisor’s) fund. While such a fund may or may not provide satisfactory returns, it may not be an effective way to get commodity exposure. Most CTA programs involve financial futures strategies, not tangible commodities. While their returns may not be correlated to equities, they are also not returns of commodities as an asset class. Even if a CTA includes tangible commodities in its fund, the program may use substantial leverage and may also go short, so an investor will have far more or far less commodity exposure than he or she might have expected. Finally, a CTA’s fees may be reasonable from a trading perspective, but they are astonishingly high for adding asset class exposure (beta): typically 2% annually plus 20% of profits.
Non-diversified commodity sector funds such as ETFs, oil and gas leases, mineral rights, timber, alternative energy plays, single-commodity and single-sector ETFs are problematic. Some of these are liquid and some require the investor to give the manager an extended notice period of the desire to withdraw funds (i.e., long-lockup periods). By definition, they are all non-diversified and can be expected to have a higher volatility than a diversified fund, though they may meet some investors’ needs. Because they are not diversified, they do not provide efficient exposure to the commodity asset class.
The best way to get commodity exposure is to invest in a rules-based, long-only fund or a private account with the same characteristics. Managers will typically not demand a profit share for providing asset class exposure.
This brings us to roll-date congestion; the legal practice of trading by floor brokers in anticipation of a fund’s rolling of its futures contracts from a nearby month to the following month. Since the major published commodity indexes specify that this rolling will be done at the settlement prices on particular dates, the returns of the investments that replicate such indexes are affected by such floor broker trading. TAP avoids roll-date congestion by rolling at dates and times at the discretion of the fund managers.
The emergence of diversified commodity funds represents a major opportunity for investors. Tangible commodities, like equities and bonds are a core asset class that should be included in every diversified portfolio.
Note: Past performance is not necessarily indicative of future results.
Dr. Henry G. Jarecki is chairman of Gresham Investment Management, www.greshamLLC.com. He developed the TAP methodology and remains significantly involved with its implementation. He has more than 40 years experience in commodities and is one of the pioneers of commodity futures investing. In 2005, Jarecki was inducted into the Futures Industry Association Hall of Fame.