HardAssetsInvestor

The Role Of Commodities And Timberland In An Institutional Portfolio

Introduction

Over the last several years, institutional investors have more than doubled their allocation, to over $110 billion, to financial products whose returns are linked to those of commodity indices. Commodities may be attractive due to the low correlation between the returns of commodities and those of other asset classes, the high correlation of commodities returns with unexpected inflation, or the rising demand for commodities from fast-growing emerging markets countries, such as China and India.

However, this increase in allocations has started to affect the pricing of the underlying commodities. While we do not recommend a strategic (policy) allocation to commodities for most clients, our recommendation for clients who do wish to invest in commodities is to do so in a way that avoids the market impact of trades currently being executed for commodity index investors.

There are at least four types of investment strategies that include commodities to at least some extent. Investors can choose to invest in commodity-linked equity securities, commodity index futures, actively managed commodity funds or funds that trade commodity futures in addition to financial futures. While we do not advocate investments in commodity index products or dedicated allocations to commodity-linked stocks, there are potential opportunities for skilled active managers in other forms of commodity investments. To best earn the benefits of commodity investing, we advocate investing with skilled active managers that approach commodity markets from a fundamental perspective. While many investors may be attracted to the risk reducing and inflation hedging properties of commodity investing, we do not believe that a strategic allocation to commodity investments is appropriate for most investors.

The Case for Commodities

The case for commodities is based largely on their historical tendency to offer returns that exhibit a low correlation with those of stock and bond market indices. While commodities can be volatile, their low correlation with traditional investments can result in a significant diversification benefit. Table 1 shows the correlation between two commodity indices, the S&P GSCI Commodity Index and the Dow Jones-AIG Commodity Index (DJ-AIG), and traditional investments and inflation indices since 1994. Over the last fourteen years, a small allocation to commodity futures investments would have substantially reduced portfolio volatility.

Commodity futures investments have historically offered their strongest returns during times of declines in traditional stock and bond market investments. Figure 1 shows the performance of commodity futures sorted by the return of the Wilshire 5000 stock market index during the period.

From 1991 to the first quarter of 2007, the Wilshire 5000 index declined by an average of -8.0 percent during 20 percent of calendar quarters with the largest stock market declines. During these quarters of sharp stock price corrections, the S&P GSCI commodity index averaged a total return of 6.4 percent, while the Dow Jones-AIG commodity index returned 3.9 percent. Each commodity index experienced its largest gains during times of stock market declines. Conversely, the only periods in which the commodity indices consistently experienced losses are those in which the stock market indices posted their largest gains.

Figure 2 tells a similar story, comparing the returns of commodity indices to those of the Lehman Brothers Aggregate Bond Market Index. In the 20 percent worst quarters for bond markets, the Lehman Aggregate returned -1.0 percent and inflation linked bonds (TIPS) fell by 0.4 percent. During these quarters of weak bond markets, the commodity indices offered their highest returns: 6.4 percent for the S&P GSCI and 5.0 percent for the DJ-AIG.