Commodities poised for entrance
The disappointing results in most equity markets during 2000 have stimulated investor interest in exploring alternatives to the equity and fixed income markets. The highly visible rise in energy prices since February 1999 has heightened institutional and individual investors’ sensitivity to the negative effect that higher commodity prices can have on their disposable incomes and investment portfolio returns. Several major US endowment and pension funds added an allocation for commodities to their investment portfolios earlier last decade. More recently, pension funds in Europe have begun to explore the alternatives available to them in the traditional commodity markets, and some have begun to invest.
Historically, commodities have provided portfolio diversification benefits to investors in financial assets, while delivering a competitive and attractive, long-term, risk-adjusted return. Since 1970, an investment in the Bridge Commodity Research Bureau Index (CRB), unleveraged, but fully collateralised with US treasury bills, would have generated a return greater than that of the Salomon Brothers Long-Term High-Grade Corporate Bond Total Return Index, but less than that of the Standard & Poor’s 500 Composite Total Return Index and the Morgan Stanley Capital International Europe, Australasia, Far East (EAFE) Index (see table 1). The volatility of the returns from the CRB would have been less than the volatility of the S&P and EAFE, but greater than that of bonds over the same period.
Perhaps the most compelling reason to consider adding commodities to an investment portfolio is the diversification benefit that may be derived. On a historical basis the CRB has been negatively correlated with the S&P, EAFE and bonds (see table 2).
A negative correlation between two asset classes indicates that as one asset class has an above-average performance, the other asset class tends to have a below-average performance, but not necessarily a loss. Commodities have repeatedly exhibited this tendency with respect to stocks and bonds, perhaps best illustrated by looking at the inflationary 1970s versus the more favorable conditions for stocks and bonds in the past two decades (see table 3).
In both periods the total return from investing in the passive commodity index exceeded the rate of inflation, but much more so in the highly inflationary times. Equity and fixed income market analysts have frequently failed to look at the total return from investing in commodities and, as a result, have significantly understated the return available from the commodities markets. The CRB index is a futures price index. “Owning” the price exposure to a futures contract only requires the posting of a small fraction of the futures contract’s value in US treasury bills. Conservatively, an investor could purchase US treasury bills with the money allocated to an investment in commodities, earn interest on those treasury bills, and still participate in the appreciation or depreciation of commodity prices in the futures markets.
Given the positive risk-adjusted return characteristics of commodities and their negative correlation with stocks and bonds, it is not surprising that adding commodities to an equity and fixed income portfolio will improve the risk-adjusted performance of the investment portfolio (see figure 1).
Recent studies have shown, however, that when major market dislocations occur, correlations between some markets tend to increase dramatically. As a result, investors need to look at how well a particular asset class performs when there is a negative shock to another asset class. Table 4 highlights how well commodities have performed over the 1970–2000 timeframe, when the S&P, EAFE and bonds experienced negative quarterly returns.
The CRB quarterly outperformance includes those rare instances when commodities generated a negative return during the same quarter as stocks or bonds. Of the 37 quarters in which the S&P return was negative, EAFE returns were negative in 23 and bonds were negative in 21. Clearly, commodities markets have tended to perform well during the worst of times for financial markets, while extremely poor performance in one financial market is frequently accompanied by poor performance in others.
The preceding comparisons focused on the returns from a passive commodity index, the CRB. Commodities, however, are more susceptible to the actions and reactions of producers and consumers than stocks of individual companies, which have an intrinsic return driven by the expectation of future growth, strong management and copyright and patent protection. As a result, commodities exhibit a strong tendency to revert to a mean as they move through various stages of their production and consumption cycles. This behaviour is highlighted by the following simplistic example.
The blue area in Figures 2 and 3 represents the cumulative total return under a “buy-and-hold” approach for a basket that is equally weighted at the investment’s inception on January 1, 1972. The red area represents the cumulative net improvement (if any) to the passive return from rebalancing the basket (“pare back-plow back method”) on an annual basis so that all components have an equal dollar weighting at the start of each calendar year. The equity portfolio represents an unleveraged investment in the 30 equity components of the Dow Jones Industrial Average (DJIA). The commodity portfolio represents an unleveraged investment in the 17 components of the CRB. In periods prior to the existence of futures contracts for a particular commodity, the portfolio was allocated equally among those commodities with then existing futures contracts.
The graphs illustrate how the opportunities to improve returns from active management differ for commodity and equity investments. For the period from January 1972 to December 1999, the commodity portfolio more than doubled its total return and reduced its volatility by employing a simple, annual rebalancing, while the equity portfolio’s total return and volatility remained virtually the same under both approaches.
These results highlight the strong tendency of commodity prices to revert to a mean as a result of supply and demand dynamics. As prices move higher, producers look to increase production to capture the additional revenue being made available, while consumers search for lower-priced alternatives or economize on their consumption. Lower prices, on the other hand, lead to reduced production and increased consumption. As such, commodities tend to become victims of their own successes and beneficiaries of their own failures. This suggests that there are significant opportunities through active management to materially improve the return potential of a commodities investment over that generated under a passive approach, such as the CRB.
Historically, the CRB has provided returns that are attractive to investors with a well-diversified portfolio. The behaviour of individual commodity markets provides additional opportunities to add value through active management. The use of commodities in institutional portfolios, which began in the US and has recently spread to Europe, is likely to increase as the longest equity bull market in history appears to have drawn to an abrupt close.
Wayne Peterson is president of Morgan Stanley Dean Witter Commodities in New York