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.
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.
|Correlation with||S&P GSCI||DJ-AIG|
|DJ Wilshire 5000 Index Lehman Aggregate Bond Index Consumer Price Index (CPI) Treasury Inflation-Protected Securities (TIPS)||0.04 0.03 0.18 0.16||0.10 0.02 0.15 0.17|
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 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.
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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