FC Investor
World Wide Web

In Focus #66: September 29, 2008

An Economic Analysis of Equity-Indexed Annuities

Optimizing Your Retirement Income: What Works Best and Why

Politics & The Estate Tax & Celebrity Estates

Insurance Products and Taxes: Keeping Uncle Sam at Bay

Spice It Up

Reprinted from Financial Planning Magazine, June 2008
Craig L. Israelsen, Ph.D.

ommodities have been around for a long time. Soybeans, live cattle, lean hogs, heating oil, gasoline, sugar, crude oil, cotton, coffee, natural gas, wheat, corn, gold, zinc�you get the picture.

Only recently have commodities become a staple in many investment portfolios. No wonder�between 1998-2007 the performance of the two most prominent commodity indexes beat the S&P 500 Index by over 300 bps.

I'll leave the technicalities of contango and backwardation to some really smart person in Geneva or Chicago. Suffice it to say that funds which invest in commodities utilize a sophisticated array of structured notes and futures contracts. If you're trying to explain how mutual funds work to your 13-year child, don't start with commodity funds.

As shown below, there are a number of commodity indexes:

Commodity Index Launch Date Historic Data From

S&P Goldman Sachs Commodity Index (GSCI) January 1991 January 1970

Dow Jones-AIG (DJ AIG) July 1998 January 1991

Rogers International Commodity Index (RICI) July 1998 July 1998

Deutsche Bank Liquid Commodity Index (DBLCI) February 2003 December 1988

Reuters-Jefferies/CRB (RJ/CRB) June 2005 January 1994

Merrill Lynch Commodity Index eXtra (MLCI) June 2006 June 1990

Lehman Brothers Commodity Index (LBCI) July 2006 December 2000

Diapason Commodity Index (DCI) July 2006 December 1997

CX Commodity Index (CXCI) November 2006 December 1996

CYD Commodity Index (CYD CI) November 2006 December 1979

UBS Bloomberg Constant Maturity Comm. Index January 2007 October 1997

Source: Deutsche Bank Guide to Commodity Indicies July 2007

The most prominent commodity indexes are the S&P GSCI (hereafter GSCI) and the DJ AIG. The purpose of this article is to assess how these two commodity indexes behave. More importantly, we will assess how they can benefit the risk-adjusted performance of an investment portfolio.

These two prominent commodity indexes behave similarly as noted by a 16-year correlation coefficient of .88 (based on monthly total returns). However, the path of the GSCI is more volatile than the DJ AIG. As seen below in "Higher Highs and Lower Lows", the GSCI had more upside and more downside over the 16 years from 1992-2007.

The 16-year annualized return of the GSCI was 7.7% with a standard deviation of 26.1%, a worst-year loss of -35.8%, and a max one-year gain of 49.7%.

The Dow Jones AIG was "tame" by comparison with a 16-year annualized return of 8.8%, but with a standard deviation of return of "only" 16.7% -- 36% lower than the GSCI. Its worst one-year loss was -27.0% and best one year gain was 31.8% -- both lower than the GSCI.

Higher Highs and Lower Lows

Very few people invest solely in a commodities-based fund. Rather a commodities fund is typically added to a portfolio of traditional assets. Thus, the only logical measure of a commodity fund is to assess how it behaves in a broadly diversified portfolio of investment assets.

I assembled a portfolio of typical asset classes and then added each commodity index (separately) to assess the value of adding "commodities" to a portfolio. Before looking at the results, let's check out the correlation between core portfolio assets (large US stock, small US stock, non-US stock, bonds, cash) and the two most prominent commodity indexes (see "Correlation"). As shown, correlations tend to be very low for both commodity indexes. On average, the GSCI has had slightly lower correlations with core portfolio assets over the past 16 years. Low correlation between portfolio assets is a wonderful thing-and commodities win the prize for low correlation.

For instance, the correlation between the large US stocks (S&P 500) and small US stocks (Russell 2000) over this same 16-year period was 0.70. The S&P 500 and the non-US stocks (MSCI EAFE) had a 0.69 correlation. (A correlation of 1.00 indicates perfect positive correlation while -1.00 equals perfect negative correlation). With such high correlations between core asset classes, the appeal of commodities is clear.

Correlation

Correlation between commodity indexes and core portfolio assets between 1992-2007

Correlation with GSCI

Correlation with

DJ AIG

S&P 500

0.00

0.10

Russell 2000

0.12

0.18

MSCI EAFE

0.14

0.24

LB Aggregate Bond

0.05

0.01

3 Month T Bill

-0.04

-0.04

Now, to the assessment of adding commodities to a portfolio. The portfolio in this analysis consisted of large US stock, small US stock, non-US stock, US bonds, and cash. Each asset was equally weighted and the portfolio was rebalanced (to equal weighting) at the start of each.

Viewed in isolation, both the GSCI and DJ-AIG are volatile assets. As shown in "Portfolio Partners" both commodity indexes in this analysis have high standard deviation of return and large one-year losses. However, a well designed portfolio is more than the sum of its parts-particularly when the parts are not highly correlated.

By adding commodities (either the GSCI or the DJ AIG) to the portfolio (now an equally weighted 6-asset portfolio) performance was enhanced and volatility was reduced (as measured by standard deviation of return and worst case one-year loss).

Adding the GSCI to the 5-asset portfolio lifted the 16-year average annual return 42 bps from 8.35% to 8.77%--or over $2,000 more in account value after 16 years. The impact of the DJ AIG Index was very similar in terms of performance enhancement (8.35% in the 5-asset core portfolio to 8.68% with the DJ AIG added). The standard deviation of return after adding either commodity index to the 5-asset portfolio was lowered in both cases, as was the worst-case one-year loss. The maximum one-year gain was virtually identical with commodities in the portfolio.

Near the bottom of "Portfolio Partners" is a row titled "Worst 3-Year Cumulative % Return". It could be titled, "�this is why we diversify!" Notice that a sole investment in US large stock suffered a cumulative 3-year loss of nearly 38% (during 2000-2002). The worst 3-year period for small stock was a loss of 21%, while non-US stock took a 43% hit from 2000-2002. The worst 3-year cumulative return for bonds was just over +11% while cash had a 4.2% worst-case 3-year cumulative return. The GSCI by itself had a 3-year period (1996-1998) with a cumulative loss of 26%. The DJ AIG's worst 3-year cumulative loss occurred during the same three years, but was considerably smaller at -13.2%.

In the 5-asset portfolio, the worst 3-year cumulative loss was -14.17%. Now add the GSCI and the worst 3-year loss drops to -4.50% while the return (as previously noted) increased by 42 bps. If using the DJ-AIG, the worst 3-year loss was -6.1% with an increase in return of 33 bps.

It's not enough to diversify a portfolio using traditional assets. Low correlation assets, such as commodities, are needed to reap the full benefits of diversification. Building portfolios is like making salsa. Good salsa uses ingredients you might not consider eating individually-too spicy. But, when those spicy ingredients are blended together in the ideal proportions, the result can be surprisingly mild and delicious product. Commodities are a spicy ingredient individually, but when added to a portfolio the end result is a portfolio with considerably improved downside protection. And frankly, downside loss is a portfolio ingredient that no one wants.

So, how does one add commodities to their portfolio? Below is a short list of several commodity funds and ETFs and the index they track.

Commodity Index

Funds

ETF�s and ETN�s�

GSCI

BlackRock Commodity Str A� (MDCDX)

GoldmanSachs CmdtyStgy A� (GSCAX)

Oppenheimer Cmdty St TR A� (QRAAX)

Rydex Commodity Strategy A� (RYMEX)

iShares GSCI Commodity (GSG)

iPath GSCI Total Return ETN (GSP)

DJ-AIG

Credit SuisseComRetStr A� (CRSAX)

PIMCO Comm Real Ret Str A� (PCRAX)

iPath DJ-AIG Commodity (DJP)

DBLCI

--

Powershares DB Comm Index (DBC)

Enjoy the salsa.