Does Commodities Investing Mean Too Much Diversification?

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  1

  MrRosemary

  07/29/09 | Report as spam

  RE: Does Commodities Investing Mean Too Much Diversification?

  When discussing the utility of an alternative (e.g. not bonds or equities) investment, it would be more helpful to see what the correlation is to a benchmark rather than volatility. As you've demonstrated, commodities do indeed have much more variability than even foreign equities. But that's only a piece of it.
  
  When compared to say the S&P, to what degree are they correlated? The biggest issue I run into when constructing a diversified portfolio is not asset classes. Rather, it is finding appropriate investments without significant correlations to each other. Obviously, we can look at the R squared, but for bonds that seems to be the T-bill and for equities the S&P 500. What I would be most interested in hearing about is going beyond index correlation and looking at overall correlation.
  
  This also is my concern with commodity ETFs. Whereup on time orange juice, coffee and pork bellies may not have had a significant correlation, when bundled into a basket of stocks for use in an ETF, logic implies that there will be an increasing correlation between those items simply based on the bulk purchase alone.
  
  Is this going to be a significant detriment to the utility of commodities going forward?

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  2

  larry swedroe

  07/29/09 | Report as spam

  RE: Does Commodities Investing Mean Too Much Diversification?

  One of the benefits of a diversified and rebalanced portfolio of commodities is that they have very low correlation to each other and they have high volatility--so you have a large diversification return.
  
  There is no logical reason IMO to think this should change as why would there be a logical reason to believe that zinc prices will suddenly correlate with cotton prices or orange juice and gold or oil and cattle? They are subject to very different supply and demand conditions.
  
  Also remember that CCF are investments in futures and don't really impact spot prices. The only way they influence spot prices if the futures buyers ultimately take delivery and without the commodities from the market (reducing supply). But to do that they must bear the costs of storage including the cost of financing the inventory, insurance and the storage itself.
  
  Note that there are only two asset classes that appear to have negative correlations over the long term to equities and they are CCF and TIPS. The rest logically have positive correlation as they are subject to the same types of economic and political risks as the S&P in general.
  
  The most important part of my message was that investors should not make the mistake of thinking of assets in isolation, but how their addition impacts the risk and return of the portfolio. Any analysis that fails to do that is flawed.
  
  Now one might still look at the analysis on a portfolio level and come to a different conclusion. Investing is not an exact science like physics and thus two people can come to different conclusions.
  Hope that is helpful
  
  
  

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  3

  MrRosemary

  07/29/09 | Report as spam

  RE: Does Commodities Investing Mean Too Much Diversification?

  I had forgotten about the futures and not the spot prices. One other concern I have about commodities is again related to futures. What am I missing here? They seem to be a zero sum game. For every winner, there is a loser.
  
  We all can own one share of a stock and when that stock goes up, we all profit. But futures have a winning side and losing side. Since a lot of these ETFs use the T bill as collateral, it seems that over a very long period of time you would end up with little more than the returns of treasurys less expenses.
  
  GLD supposedly has physical assets of gold in store, so I will except it as a good example. But in the area of other commodities, that's not the case.
  
  

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  larry swedroe

  07/30/09 | Report as spam

  RE: Does Commodities Investing Mean Too Much Diversification?

  Yes commodities futures are a zero sum game. And there is no real expected return from owning individual commodities--the expected return would be the inflation rate. However, we do not invest in individual commodities. Instead you invest in a portfolio of individual commodities. And because of the very low correlation of the commodities within the index/portfolio and their high volatility there is a significant diversification return that results: The portfolio's return will exceed the weighted average return of the individual components.
  
  The portfolio will have a lower volatility than the individual components. That smooths the returns of the portfolio and dampens the negative impact of volatility on annual returns. Consider this example:
  
  Two commodities in index, equal weighted, say $100 invested in each. A goes up 25% year one ($125)and B goes down 25% ($75). So portfolio return was 0 (same $200). Now you rebalance the portfolio to have equal weighting. So you sell $25 of A to buy $25 of buy so you once again have $100 in each. Second year A goes down 20% ($80), so two year annualized return of A is 0%. B goes up 33% ($133), so two year annualized return of B is 0. What is portfolio return? Is it zero? You have 80 +133 or $213. Or roughly 6% annualized return of the portfolio. Admittedly an extreme example, but it illustrates the point about the diversification return. Note however that the diversification return has historically been 2-4%. And it has resulted from the low correlations and high volatility of the individual commodities. And I cannot think of any reason why this should not continue as individual commodities are subject to different supply and demand factors. Note it is the smoothing of the portfolio returns that reduces the negative impact of volatility on the annual returns. Note the annual return of A was 2.5% and the annual return of B was 4%, yet the annualized return of both was zero.
  
  As to tbills as collateral. First, that is one reason I prefer the PIMCO Fund because it uses TIPS, allowing them to earn the term premium without taking the inflation risk of longer bonds.
  
  Second, even using your example of tbill returns, you are making the same mistake I have been warning against--looking at things in isolation. You can have a low returning asset that when added to a portfolio improves the risk-adjusted returns because of its correlation and volatility characteristics. That is what the historical evidence on CCF shows, as the examples I gave demonstrate. This "lesson" is a very important one and should be remembered whenever you look at an asset class, or any investment: Do not look at it in isolation.
  
  Hope that is helpful

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  5

  MrRosemary

  07/30/09 | Report as spam

  RE: Does Commodities Investing Mean Too Much Diversification?

  Thank you for the advice. Moral of the story -- Gestalt thinking helps.

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  6

  dkbika96

  08/02/09 | Report as spam

  RE: Does Commodities Investing Mean Too Much Diversification?

  dear Larry,
  fascinating and educational for me to follow your writings.
  please clue me in on CCF.
  thanks,
  dkbika96@lycos.com

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  7

  larry swedroe

  08/02/09 | Report as spam

  RE: Does Commodities Investing Mean Too Much Diversification?

  dkbika96
  
  CCF stands for collateralized commodities futures (typically meaning FULLY collateralized---there is no leverage)
  
  If you want to learn more about them I suggest you read the chapter in my book, The Only Guide to Alternative Investments You'll Ever Need.