10/05/2006

Commodity Exchange Traded Funds as Investments

By Martin Gremm

In the 1990s, every conversation about investments revolved around tech stocks. After the tech bust in 2000, the topic changed to real estate. Now that the real estate market is cooling, the focus has switched to commodities. Oil and gold in particular have posted very strong returns in recent years, and investors have taken note. New Exchange Traded Funds (ETFs) that hold a basket of commodity futures have given individual investors easy access to this market.

Tech stocks turned out to be a good investment only for those who managed to sell before the bust. Real estate looks poised to repeat the pattern. This raises the question: do commodities have a place in an investment portfolio?

Commodities as Long-Term Investments

To begin addressing this question we need to switch focus from the strong returns during the last few years to the long-range historical picture. Goldman Sachs maintains a broad commodities index comprised of futures on energies, metals, livestock, and agricultural products. From 1970 to 2005 this index returned on average 14.9% annually compared to 9.1% for the S&P 500. The average annual returns since 2002 are 23.9% and 3.8% respectively, explaining the current interest in commodities.

The worst year for the S&P 500 was 1974 (-29.7%) and for the Commodities Index it was 1998 (-35.8%). The Standard Deviation (the magnitude of a typical fluctuation) for the S&P 500 is 16.7% and for the Commodities Index it is 24.2%. Both of these measures indicate that investing in the Commodities Index involves significantly more risk than investing in the S&P 500, making it unsuitable for investors with lower risk tolerances.

Another consideration is that typically periods of significantly above average returns are followed by periods of below average returns. After four years of nearly double the normal returns, it would not be surprising if commodities took a breather at some point in the foreseeable future.

Commodities as Diversification

The Commodities Index may be suitable as part of a diversified portfolio: The worst year for the S&P 500 (1974) was a strong year for Commodities (+39.5%) and the worst year for Commodities (1998) was a good year for the S&P 500 (+26.7%).

This anecdotal evidence suggests that a portfolio of the S&P 500 and the Commodities Index could smooth out the return stream. Historically, many macro-economic drivers have affected these two asset classes in opposite ways. For example, skyrocketing commodity prices tend to coincide with economic downturns and periods of poor performance for stocks.

External shocks to the financial markets tend to cause panic selling of stocks and panic buying of commodities. The latter occurs because in times of uncertainty, the businesses that consume commodities try to ensure that they have sufficient supplies.

A more precise measure of the diversification benefit can be obtained by calculating the risk-adjusted return for the S&P 500, the Commodities Index, and a portfolio with equal allocations to both. The risk-adjusted return is expressed as a ‘Sharpe Ratio,’ which measures how much return is generated for a unit of risk measured by the Standard Deviation.

The Sharpe Ratio for the S&P 500 is 0.54; for the Commodities Index it is 0.62; and for the equally weighted portfolio it is 0.95. The blended portfolio has nearly double the risk-adjusted return of the S&P 500. This is due to an increase of the average annual return from 9.1% to 12.0% and a decrease of the typical annual fluctuation (Standard Deviation) from 16.7% to 12.7%.

While this sounds quite attractive, it is important to note that this diversification benefit is only available to long term investors who maintain the even allocation to the two instruments year after year. There are many years in which the blended portfolio underperformed the S&P 500 significantly. For example, in 1998 the blended portfolio returned -4.5% compared to 26.7% for the S&P 500. The year before, the blended portfolio underperformed the S&P 500 by 22.5%. Few investors would have the discipline and conviction to stay with their allocation after two such years.

Implementation

In the past, investors interested in this form of diversification were faced with the difficulty of establishing and maintaining a futures trading account, determining the appropriate mix of commodities, avoiding physical delivery of the commodities (Who wants a few hundred pork bellies in the front yard?), and a host of other issues.

The recent interest in commodities as investment vehicles has changed all of that. On July 24 2006, an ETF (Ticker: GSG) was launched that tracks Goldman Sachs’ Commodities Index. This ETF makes it easy for individual investors to include exposure to a basket of commodities in their portfolio.

Commodities expose investors to different risks than stocks and bonds. This makes them powerful tools for diversification and risk management, but also requires potential investors to proceed with caution. Please consult a qualified advisor before making investment decisions.