Investing in Commodities: The Search for Diversification

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As global market volatility continues, it remains increasingly important that institutional investors aim to reduce volatility through diversification. Investors of diversified portfolios are continually looking for uncorrelated investments in an attempt to reduce unsystematic risk and improve the risk/return profile of the total portfolio. Many investors have looked to the alternative asset classes as a way to provide this sought-after diversification. Alternative investments such as private equity and real estate have been a key part of institutional portfolios for over 20 years, but there continues to be a search for newer opportunities. One alternative asset class that has grown in attractiveness in recent years is Commodities. According to Bloomberg, California Public Employees' Retirement System, a $240 billion pension fund, is planning to increase its Commodities investment to $7.2 billion (3% of its assets) through 2010.

Commodity investments, which fall under the real assets category of the alternative asset class, have many characteristics that make them attractive to institutional investors. Commodities are broken into several main categories such as energy, agriculture, livestock and metals. These groupings are comprised of numerous raw materials, including natural gas, crude oil, aluminum, copper and gold. Investment in this asset class is typically gained through the use of commodity futures.

The Benefits of Diversification

Commodities have historically provided an excellent diversification benefit when combined with the traditional asset classes. Both the Dow Jones AIG Commodity Index and the S&P GSCI Commodity Index show very low correlation with several other asset classes that are typically part of a broadly diversified portfolio, including equity, fixed income and real estate (See Exhibit 1). This characteristic, combined with consistently positive returns, will serve to lower the overall volatility and improve the risk-adjusted returns of a total plan portfolio.

Exhibit 1 - Correlation Matrix (January 2003 - December 2007) (click to enlarge)

An Example of a Blended Portfolio

Exhibit 2 demonstrates the impact of the diversification benefits of Commodities on an existing blended portfolio structure. It depicts how the addition of Commodities to a blended portfolio has produced better risk-adjusted performance over the last 3-year, 5-year and 10-year time periods ending December 2007. Portfolio A - comprised of 30% U.S. Equity, 25% International Equity, 35% Fixed Income and 10% Real Estate - is compared to Portfolio B, which includes a 10% exposure to Commodities. The inclusion of a 10% exposure to Commodities in place of a 5% U.S. Equity and 5% Fixed Income exposure generates higher returns and lowers the overall volatility of the portfolio over longer-term periods. Although a 10% allocation to Commodities is a large commitment, this analysis reinforces the case for diversification. Despite the fact that the Commodity investment has a very high standard deviation on a stand-alone basis, its inclusion actually lowers the Portfolio B standard deviation for the 5-year and 10-year time periods, while also increasing returns.

Exhibit 2 - Blended Portfolio with and without Commodities as of December 2007. (click to enlarge)

Inflation Protection

In addition to diversification benefits, Commodities have historically provided a strong inflation hedge. Since Commodities are real goods and raw materials, they are directly linked to the rising prices that drive inflation. In times of unexpected inflation, Commodities can act to counter-balance the equity and fixed income asset classes, which typically under-perform during these periods.

The Challenge of High Volatility

The returns of the S&P GSCI Commodity Index have yielded high returns over long-term periods, but also high volatility on an individual asset class basis. The S&P GSCI Commodity Index produced large negative returns in 1998, 2001 and 2006, but large positive returns (average of 29.8%) in 7 of the past 10 calendar years. This extremely high volatility on an individual asset class basis may deter some investors, but is less significant in the context of a diversified portfolio. Exhibit 3 shows the historical frequency of monthly returns of the S&P GSCI Commodity Index relative to the Russell 3000 Index. As demonstrated in the chart, the Commodity index has a larger frequency of returns that depart from the median. The monthly return history has a median range between -2% and +4% for each of the two indices. Over the past 10 years, the S&P GSCI Commodity Index has generated returns outside of the median range 72% of the time. In contrast, the Russell 3000 Index has generated returns outside of that range during 43% of those periods.

Exhibit 3 - Frequency of Monthly Returns (1998 - 2007)

Beware Sector Exposure

Another challenge for those that invest in Commodities is the sector exposure allocation that is employed within the portfolio. The categories or sectors have different factors that affect pricing volatility, so it is critical to understand these underlying exposures. The two most popular Commodity benchmarks are the S&P GSCI Commodity Index and Dow Jones AIG Commodity Index. The biggest difference between the two indices is the exposure to the energy sector. The S&P GSCI Commodity Index historically has had a much larger allocation to the energy sector. As of early 2008, the DJ AIG Commodity Index has an energy weighting of 33% versus 72% for the S&P GSCI Commodity Index. Exhibit 4 shows the sector weightings as of early 2007.

Recently, the JPMorgan Investment Bank created the JPMorgan Commodity Curve Index, which provides more diversification (35 Commodities vs. 24 for the S&P GSCI and 19 for the DJ AIG) and a lower energy weighting (50%) vs. the S&P GSCI, while appearing to offer higher risk-adjusted returns, as measured from December 1990 to December 2007.

Exhibit 4 - Commodity Index Sector Weightings

Conclusion

Although on a stand-alone asset class basis, the volatility of Commodities has historically been very high, the benefits seem to outweigh the negatives for a diversified investor. The very low correlation of Commodities relative to most other traditional asset classes, along with the inflation hedge characteristics, are a great fit for a largely diversified institutional investor like a pension fund. Although there are many pension funds that have yet to invest in the Commodities component of the non-traditional asset classes, there has been significant growth in the assets invested in Commodities over the past 10 years. It is estimated that the Commodity investment for global pension funds stands at approximately $90 billion as of December 2007 - less than one half of 1% of global pension assets.¹ As evidenced by CalPERS’s decision to increase their Commodities allocation, we can expect investment in Commodities to continue to grow as global pension funds continue to look for ways to limit volatility of returns.

¹ Statistics from IFSL Research (“Pension Markets 2008”) and Financial Services Authority (“Growth in Commodity Investment: Risks and Challenges for Commodity Market Participants” by Emmet Doyle, Jonathan Hill and Ian Jack).