Investing in commodities has been recognized as a valuable means for achieving broader portfolio diversification, and seeking enhanced investment performance with reduced overall portfolio risk. Commodities returns have been positively correlated with inflation and unexpected inflation and have shown little or no correlation to equity and bond market returns. In seeking these benefits, investors have increased allocations to commodities markets at a rapid pace. According to data compiled by Jefferies Asset Management, LLC, based on various industry sources, including the Commodity Futures Trading Commission published reports that track the holdings of various dealers in listed futures and OTC contracts linked to a broad array of commodities, investments in commodities grew from approximately $9 billion in notional terms in 2000 to nearly $160 billion in 2009, a growth rate that exceeds 37 percent per annum (Figure 1).
During this same period, many commodity prices soared: Oil rose from $26 to $79 per barrel; gold from $288 to $1,097 per ounce; and corn from $1.89 to $3.74 per bushel. But even with such strong positive momentum, investors in certain commodities strategies have fared poorly. In fact, despite experiencing one of the greatest bull markets in commodities, commodities investors have underperformed spot indexes by as much as 5.6 percent per annum or more over the past three-, five- and 10-year periods.
The reason for this anomaly is that, outside of precious metals, most investors do not actually invest in commodities; they invest in commodities futures. The difference between investing in spot commodities versus investing in commodities futures can be enormous.
Figure 2 compares the performance of spot commodities prices with the performance of commodities futures investments over the past three, five and 10 years. Depending on the time frame, futures have trailed spot commodities by 5.6 to 11.7 percent annually (even with the inclusion of interest earned on cash collateral).1
In this paper, we explore the various ways in which investors can add commodities to an investment portfolio, including spot commodities, commodities futures and commodities equities. We then explore how investors may get closer to their goal, which is to achieve returns that are comparable to returns available in the spot commodities prices.
Investing In Spot Commodities
Investing in physical commodities is generally practical only for precious metals. For most other commodities, such as oil, natural gas, copper, corn, sugar and wheat, investment in physical commodities requires the purchase, storage, insurance, resale and delivery of the actual commodity. Managing the processes required to handle these transactions requires economies of scale and specialized expertise that is beyond the reach of most investors. Direct investing in most spot commodities can be eliminated as a viable investment alternative for a large segment of the investing population.
But the investment characteristics of spot commodities—both in terms of portfolio diversification and enhanced returns—make them a valuable investment choice for well-balanced portfolios. In Figure 3, we compare the annual underperformance and outperformance of the Spot Commodity Index to that of the Commodity Futures Index (inclusive of interest earned on cash collateral) during the 10-year period ending in December 2009. With the exception of two calendar years, 2000 and then again in 2003, the Spot Commodity Index significantly outperformed the Commodity Futures Index.3
If it were possible to invest in the Spot Commodity Index, investors would have earned a total return of 332 percent during this 10-year period, yielding a supplemental return of over 130 percent compared to the Commodity Futures Index.
In Figure 4, we review the summary statistics for two sample hypothetical portfolios: first, an equal-weight portfolio constructed using the S&P 500 and the Spot Commodity Index, and second, an equal-weight portfolio with the S&P 500 and the Commodity Futures Index. The portfolios have very different return profiles, with the portfolio consisting of the Spot Commodity Index outperforming by over 4 percent per annum, but the summary statistics around correlation and volatility are nearly identical between these two portfolios.
Before we turn our attention to developing an investable model for seeking returns that are comparable to the Spot Commodity Index, let’s examine the performance characteristics of commodities futures contracts.