A Look at Commodities Investing Over the Long Term

(MoneyWatch)  On Wednesday, we discussed a mistake many investors make when they look at commodities -- looking at the asset class in isolation instead of looking at its effect when included in a portfolio. Today, we'll look at this a little deeper.

My previous post showed that over the period January 1991-June 2009, commodities' high volatility and very low correlation to equities combined to provide a significant diversification benefit. The S&P GSCI returned just 3.1 percent during this period, but a 5 percent allocation impacted the portfolio as if it had actually returned 7.2 percent. The incremental return of 4.1 percent is a "diversification return."

While commodity returns were poor during this period, including an allocation to the asset class would have improved the risk-adjusted returns of the portfolio. You should also consider that this was a period of low inflation, when you didn't need the insurance that commodities have historically provided. There was no guarantee that history would play out that way. It's entirely possible that an "alternative universe" (one with high inflation) might have shown up. And while all the fiscal and monetary stimulus that has been recently injected into the economy does not guarantee any particular outcome, economists agree that the risk of high inflation is now significant.

Now, let's look at a longer time horizon and see how commodities impacted a portfolio. This time, we'll look at January 1970 through June 2009. We'll use the same portfolio constructions as our previous post:

• Portfolio A holds 60 percent stocks (36 percent S&P 500 Index/24 percent MSCI EAFE Index) and 40 percent Five-Year Treasuries.
• Portfolio B takes 5 percent from our equity holdings and adds an allocation to the S&P GSCI.
• Portfolio C shifts the fixed income allocation to 20-Year Treasuries.

	Portfolio A	Portfolio B	Portfolio C
Annualized Return with Quarterly Rebalancing	9.5	9.7	10.1
Annualized Standard Deviation	10.5	9.7	10.7

Once again, we see that the addition of commodities improved the efficiency of the portfolio as Portfolio B produced higher returns with less volatility than did Portfolio A, and Portfolio C produced 6 percent higher returns with just 2 percent more volatility.

The data would look even better if we limit our time frame to the period from 1970 through 1990. During this period, inflation averaged 6.2 percent as compared to the 2.6 percent experienced from 1991 through 2008. And as you would expect during a period of high inflation, the S&P GSCI provided an annualized return of 16.4 percent versus 10.8 percent and 14.0 percent for the S&P 500 and the MSCI EAFE indexes, respectively.

Whether or not the above evidence has convinced you to consider an allocation to commodities, I hope that you have learned that considering the risk and return of an asset class in isolation is a mistake. Unfortunately, it's one that many investors and even professional advisors make.