Wealth Planner:
Reducing Portfolio Risk by Investing in Commodities

Despite a recent pull back, it seems like 2006 will be another profitable year for commodities. Crude oil prices are still at lofty levels, gold hit its highest level since 1981, silver climbed to a 19-year high, and copper and platinum have also reached record highs. Higher demand from emerging markets such as China is a major factor. Precious metal prices may also be reacting to speculation that some central banks may diversify away from the US dollar and to precious metals. Global political uncertainties are also affecting commodities markets.

Whether as a way to invest in global growth or as a hedge against inflation, it makes sense to have some exposure to commodities in your portfolio. Not being correlated to stocks or bonds, they can help to reduce overall portfolio risk and increase the chances of achieving greater returns. As you can see from the chart below by adding 5 or 10% commodities to your portfolio, you can reduce portfolio risk from standard deviation of 15% down to 12% but enjoy the same rate of return.

         One way to gain exposure to commodities markets without high costs or betting on one commodity is to invest in the Finansa Global Commodities Open-ended Fund (FGC). The fund has just been approved by the SEC and will be launched in January 2007. In keeping with the feeder fund concept the FGC will feed directly into the UBS (Lux) Structured Sicav-<RICI> (CHF) B, which tracks the Rogers International Commodity Index, comprising 35 commodities. For full details on this fund please do not miss our seminar on December 14 th at the Grand Hyatt Erawan, Bangkok . Invitation shall be sent out shortly.

          Early this decade, commodities were touted as being a beneficial addition to traditional diversified portfolios, primarily due to its lack of correlation to other asset classes. Moreover, healthy growth and urbanization in China and other developing economies, alongside under-investment in the mining sector in the 1990s, would help keep commodity prices strong. In short, the perception of high and uncorrelated returns made commodities a much sought after ‘new' asset class for many portfolio managers.

          Partly, the portfolio-related surge in demand for commodities and related securities has also led to robust commodities returns, thus creating a self-fulfilling prophecy. But the rush to buy commodities has probably also been detrimental to its perceived benefits- returns have been squeezed, while ‘herding' has made commodities more volatile and more correlated with other asset classes, particular riskier ones. So have commodities, as an asset class, lived up to the hype and promise over the past few years?

          The short answer is: it depends. Fund managers who took on commodities in the past few years with the expectation of higher (risk-adjusted) returns have probably been disappointed. Managers who added commodities primarily for diversification benefits have fared better. For example, in the period from January 2003 to September 2006, a broad-based commodities index including equal proportions of energy, industrial and precious metals, agricultural and livestock, provided perhaps the worst risk-adjusted returns of the main asset classes. However, adding these commodities to the portfolio provided an important diversification benefit, shifting the ‘efficient frontier' up and to the left (Please see chart 1 below). In other words, the addition of commodities to portfolios over the past few years would have provided managers with higher portfolio returns per unit of risk.

Chart 1:

          The correlation between commodities and other asset classes provides some clues as to why, despite commodities' lower returns and higher risk, they have been beneficial to portfolios (Please see Chart 2 below). Commodities have had relatively low correlations to equities, bonds and real estate, thus providing some diversification benefit. Correlation with inflation-linked bonds is somewhat higher, suggesting commodities have also behaved as a relatively effective inflation hedge, which is not too surprising, given the inflationary influence of commodities prices.

Chart 2: Global asset correlations, January 2003 to September 2006

Source: UBS

          The big question on most investor's mind is whether commodities can continue to benefit portfolios in the long haul. The issue is important since as commodities continue to become more of a ‘mainstream' asset, correlations to other assets may rise. Indeed, some commodities, like equities and other risk assts, tend to be sensitive to global growth. Moreover, the extent to which energy and materials sectors have accounted for a bigger portion of market earnings can also lead to higher correlation. However, a diversified portfolio within the commodities asset class itself is an important factor in ensuring commodities can continue to enhance overall asset portfolio returns.

Diversification within commodities

          As noted in Chart 1, commodities' underperformance relative to equities and REITs since 2003 is intriguing, especially given the strong upward march of oil and metals prices during that period. One of the reasons being that returns over the past few years in both agriculture and livestock have been pretty flat in comparison to the other commodities, especially metals. Thus, while metals and oil prices propelled the overall commodities index toward record highs, the so-called ‘soft' commodities held returns back.

          However, the varying characteristics and performances of different commodities serve to highlight that a well-diversified portfolio or index within the commodities asset class can be beneficial. Indeed, a commodities portfolio consisting of only energy, industrial and precious metals, have a substantially worse return/risk profile i.e. efficient frontier than if agriculture and livestock were also included (portfolio standard deviation of 10%), than if these soft commodities were excluded (16% standard deviation).

Chart 3:

          The reason is that cross-commodity correlations have been fairly low, with the exception of precious and industrial metals. Livestock commodities are perhaps the least correlated to other commodities, while other commodities, too, do not exhibit high correlations across the board. In short, a diversified commodities portfolio has provided for a better return-risk trade-off.

Chart 4: Commodities correlations, January 2003 to September 2006

Source: UBS

          Can such low cross-correlations persist? Insofar as the soft commodities have not been subject to the same boom that industrial metals and energy have, and are driven by somewhat unrelated fundamentals, the answer is ‘yes'. The cyclical nature of metals and energy mean there will likely be comparatively high correlations among those commodities, though insignificant correlations to soft commodities as shown in Chart 4. Agriculture and livestock commodities are more likely to be affected by seasonal weather and harvest productivity patterns, and less so by cyclical economic activity.

          In conclusion, the addition of a broad-based commodities asset class to global portfolios has delivered on its promise over the past few years, resulting in improved risk-adjusted returns for portfolio managers. This is largely due to the relatively uncorrelated nature of commodities to other assets, rather than positive commodities returns per se .

          Diversification within the commodities asset class is also important. In this sense, the five main groups of commodities- energy, industrial metals, precious metals, agriculture and livestock show sufficiently low cross-correlations to justify their inclusion. Including the ‘soft' commodities of agriculture and livestock alongside more traditional ‘hard' commodities like energy and metals have enhanced portfolio returns significantly over the past few years, despite their low return.