The Role of Commodities in an Institutional Portfolio

Executive Summary

• Institutional investors, including public and corporate pension plans, endowments, and foundations, are rapidly increasing the portion of their assets allocated to commodity investments.

• Investments in commodity futures may improve the reward-to-risk ratio for investment portfolios, as the low correlation between commodity futures and equity and fixed-income investments reduces portfolio volatility.

• Over long periods of time, investments in commodity futures have a risk–return profile similar to that of stocks, which means that there can be substantial gains or losses in any given month or year.

• Commodity futures have a positive correlation with inflation, which can be attractive for pension plans that are required to pay inflation-adjusted benefits to their beneficiaries.

• The best way for institutional investors to access the commodity markets is by identifying skilled and active managers in the futures markets. Investing in commodity index funds, physical commodities, or equity securities are suboptimal solutions.

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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. Although commodities may 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 Standard & Poor’s GSCI (S&P GSCI) and the Dow Jones–AIG Commodity Index (DJ-AIG)—and traditional investments and inflation indices since 1991. Over the last 18 years, a small allocation to investments in commodity futures would have substantially reduced portfolio volatility.

Table 1. Correlation matrix for two commodity indices with traditional investments and inflation indices, January 1991 to September 2008

Historically, investments in commodity futures have offered their strongest returns during times of below-average returns from 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 third quarter of 2008, the Wilshire 5000 index declined by an average of –8.2% during the 20% of calendar quarters with the largest stock market declines. During these quarters of sharp stock price corrections, the S&P GSCI averaged a total return of 4.0%, while the Dow Jones–AIG Commodity Index returned 2.1%. In the second quintile, in calendar quarters when the stock market return was 0.0%, commodity indices earned their highest returns, at 6.1% and 4.8%. Each commodity index experienced its largest gains during times of below-average stock market returns. Conversely, the only periods in which the commodity indices consistently experienced losses were those in which the stock market indices posted their largest gains.

Figure 1. Performance of commodity futures sorted by return of Wilshire 5000 Stock Market Index, 1991 to third quarter of 2008

Figure 2 tells a similar story, comparing the returns of commodity indices with those of the Lehman Brothers Aggregate Bond Market Index. In the 20% worst quarters for bond markets, the Lehman Aggregate returned –1.0% and inflation-linked bonds (TIPS) fell by 0.6%. During these quarters of weak bond markets, the commodity indices offered their highest returns: 5.4% for the S&P GSCI, and 3.5% for the DJ-AIG.

Figure 2. Comparison of commodity index returns with returns of Lehman Brothers Aggregate Bond Market Index

Historically, commodities have served in a defensive role, as commodities have earned their highest return in times of weak stock and bond prices. Should these correlations persist in the future, a small allocation to commodities may serve to reduce portfolio risk by increasing returns in times of falling stock and bond prices.

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Case Study

Commodity Stocks versus Commodity Futures

Some investors have chosen to implement their views on commodity prices by investing in equity securities. The prices of these stocks may be somewhat correlated with those of commodity futures. Metals firms include, for example, Alcoa, and Anglo American, while agricultural firms include Archer Daniels Midland. In the energy sector, stocks such as Exxon-Mobil, Chevron, and ConocoPhillips may be used as a proxy for crude oil. These three companies alone make up 4.6% of the market capitalization of the Wilshire 5000 index. The energy sector as a whole comprises 11% of the US stock market, and another 4% is made up by metals, food, chemicals, and other materials companies. Given that most investors already have a large allocation in equity securities, an additional allocation to commodity-linked equities may not be the best way to express a view on commodity prices.

As an example, consider that the price of a stock is the product of the earnings per share (EPS) and the stock’s price/earnings multiple (P/E). When commodity firms have not hedged their output in the futures market, the profits of a firm (i.e. EPS) will be highly correlated with the prices of the commodities it produces. These profits give the firm a desirable commodity market exposure (beta), such that this portion of the stock price is responsive to changes in commodity prices. However, each firm also has a P/E ratio, which can vary with the level of the stock market. This introduces a potentially undesirable stock market beta into the commodity portfolio. This sensitivity to stock prices is unwelcome, as a key reason for investing in commodities is to experience returns that are uncorrelated with those of equity markets. In fact, commodity stocks are likely to underperform commodity futures during times of high inflation. When inflation and commodity prices are rising, stock prices are typically declining. Should the price/earnings ratio of commodity stocks decline in a bear market, the investor may not realize the anticipated benefit of the commodity firm’s profits in terms of stock price appreciation. Commodity futures are a more direct way to earn the diversifying benefits of commodity investments without increasing the stock market risk of the overall portfolio.

In the first quarter of 2008, energy stocks and commodity futures indices moved in opposite directions. Even though oil prices were increasing (commodity beta) and commodity futures indices rose as much as 18% in the quarter, the stock market was decidedly negative. Energy stocks fell 8% during the quarter, as the US stock market declined nearly 10% in the quarter. While energy stocks had a higher return than the broader market, there remained a large gap between the performance of commodity stocks and commodity futures.

Though energy, metals and agricultural commodities are well represented in the futures markets, there are other commodities for which futures markets do not currently exist. Markets such as those for water, coal, steel, chemicals, and renewable energy can only be accessed by investors through equity securities. Firms that produce capital goods needed for exploration and production, or to maintain ownership, of commodities in these sectors represent a relatively small part of the equity market, and futures contracts are not available. Although investment in commodities through stocks in the energy, metals, and agricultural sector is not advocated, investors who desire exposure to these other commodity markets may do so using stocks.

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Commodity Futures Indices

The two most commonly used commodity futures indices are the S&P GSCI and the Dow Jones–AIG Commodity Index. Table 2 shows the allocation of each index to various commodity markets. Note that the energy markets represent 76% of the GSCI. In contrast, the DJ-AIG index intentionally limits exposure to any single sector to around 33%. Investors may prefer the DJ-AIG index to gain a potential improvement in the risk–reward tradeoff, as the overweight given to energy commodities in the GSCI has historically resulted in higher volatility without a corresponding boost in returns. Since 1991, the GSCI has earned an average total return of 7.1% with a standard deviation (volatility) of 18.4%, while the DJ-AIG averaged an annual return of 8.1% with a lower standard deviation of 12.3%. Earlier, Table 1 showed that the two commodity indices share similar correlations with traditional stock and bond investments and inflation.

Table 2. Composition (%) of S&P GSCI and DJ-AIG indices as of September 30, 2008

The total return to a commodity futures index consists of three components: spot return, roll return, and yield. The spot return is the return to an investment in physical commodities. The roll return is earned in the process of passively trading (rolling) futures contracts as they mature and must be replaced. The yield is the interest earned on a short-term fixed-income investment that is pledged to the futures exchange in order to maintain the collateral required to back the futures investments. Table 3 breaks down the total returns from spot, roll, and yield.

Table 3. Decomposition of S&P GSCI returns, 1970 to September 2008

Figures 3 and 4 show some interesting characteristics of the returns on owning physical commodities. Most notably, spot commodity markets have underperformed inflation and cash over long periods of time: while the GSCI spot index earned an annual return of 4.8% since 1970, cash returned 5.6% and the US Consumer Price Index (CPI) increased by 4.6% per year over the same period. Commodity price increases have not exceeded the rate of inflation over long periods of time. As new natural resources are discovered, production technologies improve, and research advances in areas such as crop engineering and alternative energy, commodity prices tend to decline in real (after-inflation) terms.

Figure 3. Ratio of cumulative wealth normalized to cash, 1970 to September 2008

Figure 4. Ratio of cumulative wealth of spot returns normalized to cash, 1970 to September

How, then, could commodities futures have offered a total return since 1970 rivaling that of equities if the ownership of physical commodities does not offer a return that exceeds inflation? The answer is in the roll return and the collateral yield, as shown in Figure 3. (The roll return is approximated by the difference between the excess return and the spot return of the GSCI.) The roll return and collateral yield can only be earned when investing in commodity futures. The return on commodity futures investments, then, has significantly exceeded that of a direct investment in physical commodities over the last 37 years. An extended discussion of roll yield, and the relationship to contango and backwardation term structures in the futures markets, can be found in Black and Kumar (2008).

Not every investor will choose to make use of commodities in their portfolio. It can be difficult to value commodities, as their characteristics don’t neatly follow classical valuation models. Commodities do not generate a cash flow, so they can’t be valued using discounted cash flow methodologies. Because commodities have a near-zero correlation to equity indices, their beta is also near zero, which disallows use of the capital asset pricing model. Variables such as political strife and weather can have a significant impact on both long- and short-run commodity prices. These exogenous variables are extremely difficult to predict, and they create systemic risks that are not priced in traditional return forecasting models.

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Actively Managed Commodity Funds

Active management has a number of advantages over allocating assets to a commodity index fund. There are several ways in which an active commodity manager can add value relative to an investment in a commodity index. Should a manager demonstrate skill in these areas, an allocation to its managed commodity product can be supported.

First, an active commodity manager should have an intimate understanding of the shape of the futures curves in a variety of commodity markets. Commodity index funds require that investors hold long positions in the near-dated contract, regardless of the shape of the futures curve and the size of the positive or negative roll yield. Active managers, however, have significant flexibility in their selection of contract. For example, although the front-month contracts in a given market may be priced to result in roll losses, later-dated contracts, perhaps at a 12-month maturity, may be priced in such a way that investors may earn a profit from the roll. This flexibility can significantly increase the potential for a return from the futures roll. In a case where the entire futures curve for a given commodity is in contango, causing negative roll yields, an active manager may choose to reduce or eliminate exposure to that commodity. Commodity index programs also have a stated timing when they are required to roll from the front month to the later-dated futures contract. When managers follow a mechanical strategy, such as rolling 20% of their position in each of the fifth through ninth business days of the calendar month, other traders in the market become aware of the roll requirement and change their prices to maximize the market impact of that trading program. Active managers will choose to roll their positions at a date other than that of the index rolls, which can significantly reduce the market impact of their trading.

Second, commodity index investors are required to hold a certain portion of their assets in each futures market, regardless of the fundamental drivers of the spot commodity price. Active commodity managers should be able to show skill in their analysis of the supply and demand dynamics in each market. Ideally, the active manager will implement a long position only in markets where demand is likely to grow faster than supply, while avoiding or selling short in markets with less favorable supply–demand dynamics. While index investors only take long positions in commodity markets, active managers may choose to take no position or a short (negative) position in commodity markets where their analysis predicts a low probability of price increases.

Given the significant opportunities to enhance the returns from spot returns and roll investments in the futures markets, active managers who show skill in these areas may be viewed as an attractive investment opportunity. While active managers may choose to maintain significant short positions in certain commodity markets, funds that maintain a long bias in each of the major market sectors, including energy, metals, and agriculture maximize the diversification effect of the commodities investment. For commodities to play their role as a portfolio diversifier, the fund needs to maintain long positions during times of commodity price increases.

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Conclusion

Over the last 18 years, commodities have served as an excellent portfolio diversifier. Because of the historical tendency for commodity futures to have a high correlation with inflation, they typically offer higher returns than stocks, bonds, and even Treasury Inflation-Protected Securities during times of market stress. Commodities tend to be a defensive asset class and, as such, tend to underperform during bullish equity markets. Should these trends continue, investors can reduce their portfolio risk by allocating a small portion of their portfolio to commodity futures.

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Making It Happen

• Examine your investment portfolio to determine the potential value added by an allocation to commodity futures investments.

• Should you determine that commodities would improve the risk–return tradeoff of your portfolio, begin your search for an actively managed portfolio that can add value above an index fund investment.

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