Commodities as Portfolio Insurance

Last Updated Aug 19, 2010 9:47 AM EDT

Before we jump in to why adding commodities to a portfolio has improved the portfolio's efficiency, I thought a further example of commodities' effect would be helpful.

Using indexes to illustrate how an asset class's addition affects a portfolio is a close approximation to reality, since common asset classes have index funds that track their respective indexes well and do so at very low costs. However, even passive commodities funds may have very different returns than their corresponding indexes, because their expenses aren't as low as they are for the equity and bond index funds of industry leader Vanguard (which unfortunately hasn't yet offered a commodity fund), and trading costs might be higher. Thus, it's important in this case to see how a commodities strategy works in the real world, with real world costs. We'll use:
  • The PIMCO Commodity RealReturn Strategy Fund (PCRIX) for commodities (as the commodity exposure is passively managed)
  • The Vanguard 500 Index Fund Admiral Shares (VFIAX) for stocks
  • The Vanguard Intermediate-Term Bond Index Admiral Shares (VBILX) for bonds
Since PCRIX's inception was July 2002, we'll look at both the period July 2002-June 2010 and the five-year period ending June 2010.
July 2002-June 2010

Annualized Return (%)

Annual Standard Deviation (%)

Sharpe Ratio

PCRIX

9.2

31.4

0.383

VFIAX

2.5

16.2

0.097

VBILX

6.5

6.2

0.726

60% VFIAX
40% VBILX

4.5

9.7

0.284

55% VFIAX
5% PCRIX
40% VBILX

5.0

9.6

0.341

July 2005-June 2010

Annualized Return (%)

Annual Standard Deviation (%)

Sharpe Ratio

PCRIX

-0.1

38.5

0.103

VFIAX

-0.8

19.7

-0.089

VBILX

6.0

5.9

0.606

60% VFIAX
40% VBILX

2.4

12.2

0.031

55% VFIAX
5% PCRIX
40% VBILX

2.7

12.0

0.056

Once again, in both cases adding a small allocation of PCRIX improved the efficiency of the portfolio.
It's important to note that the past is no guarantee of the future. Since none of us has clear crystal balls, we can't know if the large trader's contango we have experienced in recent years will continue or if roll costs return to historical levels. We can't even know what the correlations will be, as correlations drift. (The correlation of commodities to equities prior to 2008 had been negative.)

However, the historical evidence suggests that commodities will at least likely continue providing a diversification benefit. Consider the evidence in the following tables. It shows the returns of commodities during years of negative returns to stocks and bonds.

Years of Negative Returns of Long-Term Government Bonds (1970-2009)


Year

Return of Long-Term Government Bonds (%)

Return of S&P GSCI Index (%)

1973

-1.1

75.0

1977

-0.7

10.4

1978

-1.2

31.6

1979

-1.2

33.8

1980

-4.0

11.1

1987

-2.7

23.8

1994

-7.8

5.3

1996

-0.9

33.9

1999

-9.0

40.9

2009

-14.9

13.5

Average Return

-4.4

27.9

Years of Negative Returns of the S&P 500 Index (1970-2009)


Year

Return of S&P 500 Index (%)

Return of S&P GSCI Index (%)

1973

-14.7

75.0

1974

-26.5

39.5

1977

-7.2

10.4

1981

-4.9

-23.0

1990

-3.1

29.1

2000

-9.1

49.8

2001

-11.9

-31.9

2002

-22.1

32.1

2008

-37.0

-46.5

Average Return

-15.2

+14.9

The tables show that there has been a tendency for commodities to do well when stocks do poorly, as they rose in six of the S&P 500's nine negative years. Commodities have also provided positive returns in every one of the 10 years that long-term government bonds produced negative returns -- demonstrating that they're an even better diversifier of the term risk of fixed income investments (allowing you to take more duration risk and earn the term premium). In addition, there isn't a single year when all three asset classes fell in value. This helps explain why commodities have historically improved the efficiency of a portfolio when added.

To wrap up our series on commodities, we'll look a little deeper at BusinessWeek's article on commodities, "Amber Waves of Pain."
  • Larry Swedroe On Twitter»

    Larry Swedroe is director of research for The BAM Alliance. He has authored or co-authored 13 books, including his most recent, Think, Act, and Invest Like Warren Buffett. His opinions and comments expressed on this site are his own and may not accurately reflect those of the firm.

Comments

Market Data

Market News

Stock Watchlist