Riding The Wave

September 01, 2005

There have been a number of articles published recently that highlight the appropriate role of commodities in a balanced portfolio.

The main focus of these articles has been that there is indeed a place for commodities, and that investors wishing to diversify have a number of different broad-based commodity indexes to choose from.

A comparison of these indexes, highlighting component and sector weights, is then presented.


Illustration by Robin Jareaux

Figure 1

Broad-Based Commodity Indexes

Product

Name

DJ-AIG

Dow Jones-AIG Commodity Index

GSCI

Goldman Sachs Commodity Index

RICI

Rogers International Commodity Index

RJ-CRB

Reuters/Jefferies CRB Index

SPCI

Standard & Poor's Commodity Index

Although this is a good starting point, it falls short of providing both investors and product developers with the tools required to make intelligent, well-informed decisions regarding these investments. While most articles discuss the various indexes from a component inclusion viewpoint, they do not address the different mechanisms and conventions of each index. In many cases, the highlighted index is not the investable version of a given index. This oversight is of critical importance, as it points toward the question of 'how' to invest in commodities. It is one thing to know that there are diversified commodity indexes. It is another thing entirely to know how to use them effectively when making investment decisions or designing products.

Rising Interest

The current investment environment has been a source of anxiety for many investors. Following a period of sustained growth, the equity markets have entered a period of range-bound trading, and profitable investing has become more difficult. The reduction in marginal returns on traditional investments has forced managers to actively seek out alternative investment strategies. Because this has occurred during a period of base commodity price increases, commodity- based investment products have attracted particular attention. Although crude oil prices have gotten most of the press, many other commodity sectors have posted impressive gains over the past few years.

Beyond their solid recent performance, commodities also exhibit favorable correlation characteristics when included in a well-balanced portfolio. Recent academic work has confirmed the positive effects of a commodity allocation in traditional investment portfolios.

Previously, investors seeking the beneficial effects that commodities could bring to a diversified portfolio had few alternatives other than buying physical gold or purchasing equity shares in natural resource processing and marketing firms (this includes specialty/natural resource mutual funds, which, generally speaking, hold large equity stakes in these firms). Unfortunately, investments such as these rarely pro v i ded the full benefit that could be gained by a passive, long position in a diversified basket of real commodity proxies . Although their performance is often related to base commodity prices, natural resource companies come with attendant corporate risks: inefficient management, marketing errors , hedging, overhead, malfeasance, etc. Furthermore, as I'll explain later, the performance of these companies is more closely correlated to the broader equity markets than to the commodities themselves.

Figure 2

For institutional investors, there were other options. Through the use of structured derivative products, they could acquire exposure customized to their needs.

Fortunately, this situation may be about to change. Although diversified commodity indexes have been available for over a decade, few have been available to the average investor. Several new initiatives are beginning to address this shortcoming.

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