Riding The Wave

September 01, 2005

Once prices rise to a level that supports more complex (and costly) recovery efforts, there is a great amount of difficulty in bringing new supplies to market.

Commodities are also subject to sharp price moves. Systemic shocks, such as a natural disasters or global political turmoil, which disrupt the supply chain of a given commodity, are reflected in price "crashes" to the upside. It takes a considerable amount of time for corrective actions to take effect following a systemic shock. Since there are not any effective methods for i n c reasing supply in the short term, the only thing that can "give" is the price.

Analysis of historic data also highlights an important relationship between monetary policy and the price performance of commodities as an asset class (Figure 3). Specifically, during periods of monetary contraction (rising interest rates), returns on commodities have historically outperformed those for fixed income and equities. Given the current interest rate environment, commodity-based investments look like a logical allocation for investment professionals.

Portfolio Diversification

The need for diversification is a basic tenet of modern portfolio theory. By allocating a portion of total portfolio assets into uncorrelated investments, investors can realize an increase in total portfolio return accompanied by a reduction in risk. In its simplest form, diversification take s place within a portfolio of like assets (i.e., a portfolio that holds multiple equity issues rather than a single security). More sophisticated investors also have realized the benefit to be gained by diversification among different asset classes. Historically, this has resulted in an allocation between equities and fixed-income assets.

Figure 4 provides data on the correlation of various asset classes. Traditionally, investors have diversified a portfolio by introducing bonds to an equity-based asset basket. The data make clear that commodities should be considere d when evaluating asset class allocations, as they have an important role to play alongside their more traditional counterparts. Academic studies have shown that commodities investments can enhance portfolio returns while lowering overall portfolio risk profiles.

To date, commodities have not been fully included in most allocation models. A factor in this under-representation has surely been the relative difficulty of investing in commodities for traditional asset managers. The introduction of diversified commodity indexes and associated investment vehicles should satisfy the need for a well-balanced pro duct that provides passive long exposure to the asset class.

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