An Investor's Guide To Commodities
By Larry Swedroe and Jared Kizer

This excerpt taken from Chapter 3 of The Only Guide To Alternative Investment You'll Ever Need by Larry Swedroe and Jared Kizer (Bloomberg Press, 2008). Reprinted with permission.

Commodities, which fall within the broad category of hard assets, are an interesting class from a portfolio perspective. Since 1970, they have provided relatively high returns, exhibited negative correlations with equities and bonds, and acted as a hedge against event risk. As stated earlier, the attribute of negative correlation makes an asset class an excellent diversifier of risk. Thus, commodities appear to be worthy of consideration for inclusion in a globally diversified portfolio..

We base the analysis in this chapter on evidence accumulated since 1970 on the S&P GSCI-perhaps the most commonly cited commodities index. (The other major commodity index, the Dow Jones-AIG Commodity Index [DJ-AIGCI], has price history beginning in 1991 and went live in 1999. We will discuss that index later in the chapter.) The S&P GSCI represents a broad cross section of principal raw and semifinished goods used by producers and consumers; it contains commodities from all sectors: energy, industrial, precious metals, livestock, and agricultural products. The S&P GSCI is world-production weighted, and the quantity of each commodity in the index is determined by the average quantity produced in the past five years. As of February 2008, the weightings for the S&P GSCI were as follows:

• Energy: 71.4 percent, of which natural gas was about 7 percent and the balance was oil-related commodities
• Industrial metals: 8.1 percent, of which aluminum and copper were about 3 percent and the remainder consisted of lead, nickel, and zinc
• Precious metals: 2.2 percent, of which gold was about 2 percent and silver was the remainder
• Agriculture: 15.1 percent, of which wheat was about 5 percent, corn and soybeans were about 3 percent, and cotton, sugar, coffee, and cocoa-each making up 1.2 percent or less-were the remainder
• Livestock: 3.2 percent, of which cattle was about 2.2 percent and hogs were about 1 percent

Just as the weightings of an equity index change as individual stock prices change, so do the proportions of the S&P GSCI change with changes in individual commodity prices.

The heavy weighting of energy-related commodities in the S&P GSCI contributes to the historically negative correlation of the index with both stocks and bonds. The United States has experienced more than one unexpected upward shock to energy prices. The upward shocks lead to unexpected increases in inflation (a negative for both stocks and bonds) and also act as a tax on consumers, depressing economic activity (another negative for stocks).

Figure 1, which compares returns and the standard deviation (an indicator of volatility) of the S&P GSCI to stocks and bonds from 1973 through 2007, demonstrates that the S&P GSCI provided equity-like returns with equity-like volatility. Thus, it is a risky asset class (at least when viewed in isolation).

Many investors decline to participate when they realize that the asset class is volatile, which is unfortunate because commodities can reward the patient and disciplined investor. But the investor needs to possess both traits, because such a risky asset class can provide very poor returns for a very long time. For example, for the ten-year period ending 1999, the real return of the S&P GSCI Total Return Index (S&P GSCI-TR) was just 0.9 percent. This compares to a real return of 14.8 percent for the S&P 500. For the twenty-year period ending 1999, the comparable real returns were 3.1 and 13.3 percent, respectively. And finally, for the period 2000-2007, the S&P GSCI provided a real return of 10.4 percent, outperforming the S&P 500 by more than 11 percent a year, as the latter produced a real return of -1.2 percent.

Investors may fail to realize that commodities can convey substantial diversification benefits. Investors fall into this trap when they think about the risk of an asset class in isolation. To appreciate the diversification benefit of an asset class, it is necessary to examine how including it in a portfolio might affect total portfolio risk. We approach this problem the same way we did in earlier chapters: We look for negative correlations between commodities and other asset classes.

As the analysis in the next section will show, the S&P GSCI is negatively correlated with bonds and stocks and positively correlated with inflation. Because of these characteristics and the high volatility of the asset class, including an allocation to the S&P GSCI in a portfolio has historically improved a portfolio's risk-adjusted returns.¹

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