Investing for Keeps - Article Series

Commodities As An Asset Class

By: Frank Armstrong, CFP, AIF

I began selling securities in 1974--not particularly auspicious timing. From 1973 to 1974, the US stock market lost nearly half its value. Inflation ignited, interest rates rose, stocks bombed, and bond investors were punished. In those days before money-market funds, there were no attractive financial securities. Hard assets and Treasury bills were the only investments that thrived. It took a long time for investors to recover. It's the stuff of nightmares. How can we protect ourselves when the financial markets go into a tailspin? Isn't there an attractive asset class not linked to stocks and bonds? It's the Holy Grail for asset allocators.

This defensive asset class--commodities--is becoming more and more accessible to individual investors. It's a complicated market, though, and one that requires an in-depth prologue.

Suppose you are a wheat farmer. One of your many concerns is that the price of wheat will drop just as you are harvesting. You could have a great crop, and still not be able to sell it for enough to cover your costs. Like it or not, you have what the futures market might call a long position in wheat. Fortunately, across town is a baker who is concerned that the price of wheat might go up. Because he uses wheat to make his bread, he needs to lock in what his wheat costs will be.

So, you sell your wheat to the baker now at a mutually agreed-upon price, for delivery when harvested. You have entered into a forward contract. In the more common situation, if you don't know a baker who needs wheat, you can buy a futures contract on a commodities exchange to accomplish the same result. This is not an options contract; you will deliver the wheat at the time specified, or you must buy your way out of the contract at the then-current price.

So far, you haven't done anything very risky. In fact, you have reduced the most serious risk facing your farm. As a farmer you already had a long position in wheat with a serious downside. By entering into the futures contract, you hedged away the risk of falling wheat prices. Of course, if the price of wheat goes up, you will not make as much profit. But, you will survive to farm another day.

The baker, as a commodity consumer, had a short position in wheat, and was able to hedge away his risk of rising prices by buying a long contract.

As long as we have an equal number of hedgers on either side of the contract, we have a simple zero-sum game. If the price of wheat moves from the agreed price, whatever one side "loses" the other side gains.

But what if there are more farmers concerned about falling prices than bakers concerned about rising prices? How can we "clear the market" then? Someone must supply the capital to balance the trades.

Energy	48.55%
Crude Oil Unleaded Gas Heating Oil Natural Gas	19.34 12.37 10.35 6.49

Indust Metals	9.56%
Aluminum Copper Lead Nickel Tin Zinc	4.66 2.67 0.43 0.54 0.16 1.10

Precious Metals	3.59%
Gold Platinum Silver	2.98 0.23 0.38

Agriculture	26.34%
Wheat Corn Soybeans Cotton Sugar Coffee Cocoa	7.30 6.13 3.33 4.03 2.94 2.09 0.52

Livestock	11.96%
Live Cattle Live Hogs	8.68 3.28

What this market needs is speculators--someone to buy those long positions from the farmer. But why should a speculator risk capital by buying a commodity that she has no business reason to own? After all, she doesn't really want the wheat, and if the price goes down, she's out of luck. At the end of the contract, she owns the wheat, and must sell it at the current price (also known as the spot price). (She would normally close out her contract, and realize her profit or loss, before she was required to take delivery.)

The only way our speculator is going to be attracted to the market is if she can buy the wheat at a sufficient enough discount from the expected market price to provide her with a reasonable profit. So, if there is an imbalance between buyers and sellers, then futures prices must adjust enough to provide an attractive profit potential to speculators. And it goes without saying that the profit potential must be appropriate for the level of risk.

How might such a portfolio have performed? The Goldman Sachs Commodity Index (GSCI) tracks a broad range of important commodity contracts including energy, industrial metals, precious metals, agricultural products, and livestock. (There are several other alternative indexes.) The index measures the total return that investors receive from an unleveraged, fully collateralized, passive, long-only position in the commodities. The GSCI is adjusted to account for commodity-market activity.

There are three important elements of return: A collateralized contract will earn the risk-free return, plus the risk premium, plus the change in spot prices. The long position will tend to move in the same direction with the price of the underlying commodity. After all, the contract may change hands many times, but it has a finite life. In the end, someone holds the product. Spot prices and futures prices must be the same on expiration day.

Although inflation has been low lately and poor recent returns have reflected a global collapse in commodity prices, a quick glance at the longer term is much more encouraging. The index offers an average return about equal to the S&P 500 but with somewhat higher risk. The big benefit, however, is that it marches to an entirely different economic drummer. While stocks and bonds both retreat during times of rising inflation, commodities surge ahead.

1971-1997

GSCI

MSCI EAFE

L/T Govt

3mo Treasury Bills

S&P 500 Index

Annual Return %	12.94	13.44	9.45	6.84	13.32
Growth of $1 %	26.70	30.08	11.45	5.97	29.28
Standard Deviation	22.26	22.09	12.21	2.73	16.47

As an asset class, commodities offer unique diversification benefits that show remarkably low correlation to almost all other financial assets. A small weighting in commodities may have the potential to significantly reduce risk in a diversified portfolio.

1971-1997

GSCI

MSCI EAFE

L/T Govt

3mo Treasury Bills

S&P 500 Index

GSCI	1.00	-0.21	-0.28	-0.02	-0.33
MSCI EAFE	-0.21	1.00	0.21	-0.20	0.46
L/T Govt	-0.28	0.21	1.00	-0.03	0.47
3mo Treasury Bills	-0.02	-0.20	-0.03	1.00	-0.08
S&P 500 Index	-0.33	0.46	0.47	-0.08	1.00

As an asset class, commodities offer unique diversification benefits that show remarkably low correlation to almost all other financial assets. A small weighting in commodities may have the potential to significantly reduce risk in a diversified portfolio.

1971-1997

GSCI

MSCI EAFE

L/T Govt

3mo Treasury Bills

S&P 500 Index

GSCI	1.00	-0.21	-0.28	-0.02	-0.33
MSCI EAFE	-0.21	1.00	0.21	-0.20	0.46
L/T Govt	-0.28	0.21	1.00	-0.03	0.47
3mo Treasury Bills	-0.02	-0.20	-0.03	1.00	-0.08
S&P 500 Index	-0.33	0.46	0.47	-0.08	1.00

Until just recently smaller investors were unable to participate in commodities in a convenient manner. But in March 1997, Oppenheimer created their Real Asset Fund, using bonds, Commodity Linked Notes, other hybrid instruments, and derivatives to replicate the performance of the GSCI. The fund's managers can overweight or underweight portions of the index, and actively manage the bond portfolio to enhance returns. So far, the fund has faithfully tracked the index, with an R-squared of 98.

This is not your average mutual fund. Commodities offer compelling potential advantages that cannot be duplicated by other financial assets. But they are so thoroughly different from what we usually encounter with stocks and bonds that some serious homework is in order before taking the plunge.

 

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