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Choosing Commodities Exposure For Beta Diversification
How might an investor go about choosing exactly what type of commodities exposure to include in the beta portion of a portfolio? A good place to begin might be with some basic statistical analysis. Generally speaking, correlation, when used in conjunction with portfolio analysis, determines if the prices of assets included in the analysis move in the same direction, whereas regression6 analysis examines if the movements of one asset can be explained by the movements in another asset.
Many professional investors are well aware that price movements in precious metals are generally not well correlated with the performance of stocks and bonds. However, it often comes as a surprise to investors that many commodities in the agricultural sector have price movements that are less correlated with stocks and bonds than do other well-known commodities. Figure 2 illustrates the 20-year price correlation of 13 major commodities to the S&P 500.7
Precious metals and energies can be effective beta-enhancing components in a diversified portfolio, and the popularity and presence of these two commodities sectors in many portfolios is widely known. But analysis shows that over time, the price movements of energies seem to be more closely correlated with stocks and bonds than are the price movements of agricultures and precious metals. Regression analysis, which relates to correlation by showing how much the movement of something (in this case, specific commodities) is directly affected by the movements in a comparable benchmark (in this case, the S&P 500) can often explain correlation patterns. In fact, longer-term regression analysis of 13 major commodities consistently shows gold, sugar, soybeans and corn as the least directly affected by the performance of the S&P 500 Index.
Specifically, when one performs a regression analysis of the S&P 500 Index over five-, 10- and 20-year periods8 against the 13 commodities available in the single-ETP format, those that are the least tied to the S&P 500 are consistently precious metals and agricultural commodities. (See Figure 3.) In fact, sugar is historically less tied than gold over the last 10 years, and soybeans are less tied than gold over the past five years.
As previously discussed, investors seeking exposure to commodities have easy access to a variety of commodities-based ETP products. They can choose among several multicommodity ETPs or they can customize their exposure using single-commodity funds. Again, be certain to study the underlying benchmark of your ETP choices, because benchmark design more than any other factor will be the true source of your expected performance.
Optimizing Commodities-Based Beta Through Seasonality
Seasonal patterns in many commodities—especially within the agricultural sector—are often (but not always) used by investors to optimize the beta component of their portfolio. The basic patterns and cycles of life on planet Earth, primarily those based upon growing seasons and usage patterns, can be employed effectively to optimize the timing of when investors increase or decrease beta exposure to certain commodities. These patterns are literally cosmic in nature; the positioning of planet Earth at times of solstice and equinox is ultimately what affects growing seasons and usage patterns. These cannot be affected by investors, but they can be used effectively by investors seeking beta-enhancing strategies.
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