Articles

Commodities In A Portfolio
By Sal Gilbertie

Page 6 of 6

Matching Investment Objectives To ETP Design
The wide variety of benchmark designs within the commodities ETP sector can be a benefit to investors, but only if each investor chooses the proper benchmark according to his or her own investment needs. Investors need to understand the benchmark design of the ETP considered, including the holdings and the benchmark objective.

For instance, if all an investor wants is to have immediate, short-term exposure to a given commodity or sector in order to trade alpha, then a benchmark that concentrates its positions in the front of the futures curve may be best suited to that particular investment objective. Such a design will likely capture the short-term price movements of the commodity, allowing the capture of alpha in the investment.

If one wants to have long-term exposure to a particular sector or commodity to achieve beta, then a benchmark design that mitigates contango and backwardation concerns within the futures curve might be a better selection. Efficient long-term exposure to the commodity through mitigation of potentially negative impacts of contango and backwardation is a more important consideration for a beta trader than that of capturing near-term price movements.

The objective and term of an investor's investment holdings are of critical importance when selecting the appropriate commodities-based ETP. Financial advisors as well as the sponsors of ETPs themselves are good sources of information when researching which investment selections might be most appropriate.

Conclusion
Commodities are being used very effectively as beta diversifiers in many portfolios. As addressed in the Morningstar study cited above, the inclusion of commodities in a portfolio can reduce volatility over time without negatively impacting overall returns. Investors now have access through a wide variety of ETP products to a range of principal commodities. These ETPs can differ significantly in benchmark design, which is the main driver of returns to the investor. Of the major commodities represented by single-commodity ETPs, long-term time horizon snapshots of correlation and regression studies show agricultural (specifically corn, soybeans and sugar) and precious metals (specifically gold and silver) as the two commodities sectors having the lowest relationship with the S&P 500. Additionally, investors with basic knowledge of fundamental seasonal patterns within the commodities sector can often optimize their beta exposure and/or capture alpha by using an appropriately chosen commodities-based exchange-traded product.

Endnotes
¹ Beta is calculated using regression analysis, and you can think of beta as the tendency of an investment's returns to respond to swings in the market. Source: http://www.investopedia.com/terms/b/beta.asp#axzz1tWSehkhK.

² Alpha is a measure of performance on a risk-adjusted basis. Alpha takes the volatility (price risk) of an investment and compares its risk-adjusted performance to a benchmark index. The excess return of the investment relative to the return of the benchmark index is the investment's alpha. Source: http://www.investopedia.com/terms/a/alpha.asp#axzz1tWSehkhK

³ Morningstar, "Benefits of Including Commodities in a Portfolio – Lower risk and higher return 1991-2010." Originally published on 3/1/2011.

⁴ Contango: A condition in which distant delivery prices for futures exceed spot prices, often due to the costs of storing and insuring the underlying commodity; opposite of backwardation.

⁵ Backwardation: A market condition in which a futures price is lower in the distant delivery months than in the near delivery months.

⁶ Regression: A statistical measure that attempts to determine the strength of the relationship between one dependent variable (usually denoted by Y) and a series of other changing variables (known as independent variables). Source: http://www.investopedia.com/terms/r/regression.asp#ixzz1tXVbXPIy

⁷ For this purpose, the correlation analysis for each specific commodity is spot continuation (generic futures contracts) as defined by and sourced on Bloomberg: "Generic contracts, such as US1, US2, US3, ..., are constructed by pasting together "rolling" contracts, according to the pre-selected roll types on the commodity default page. The generic contract uses the value of a particular contract month until it "rolls" to the next month in the series. You can access a generic contract by replacing the month/year code with the number 1, i.e. A 1. Replacing the month/year code with the letter A will yield the active contract." Daily data was used in the analysis for the correlation information included herein. Charts prepared by Teucrium Trading LLC as of April 27, 2012. Gasoline was not included due to the fact there was a material specification change for the specific commodity during the study period.

⁸ For this purpose, the regression for each specific commodity is spot continuation (generic futures contracts) as defined by and sourced on Bloomberg: "Generic contracts, such as US1, US2, US3, ..., are constructed by pasting together "rolling" contracts, according to the pre-selected roll types on the commodity default page. The generic contract uses the value of a particular contract month until it "rolls" to the next month in the series. You can access a generic contract by replacing the month/year code with the number 1, i.e. A 1. Replacing the month/year code with the letter A will yield the active contract." Daily data was used in the analysis for the regression charts included herein. Charts prepared by Teucrium Trading LLC as of April 27, 2012. Gasoline was not included due to the fact there was a material specification change for the specific commodity during the study period.

⁹ Seasonal commodity graphs are included with the permission of John Bernardi/Newedge USA. Graphs and underlying data prepared by John Bernardi/Newedge USA as of April 2012.