Commodities as Portfolio Insurance
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
| 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 |
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 |
To wrap up our series on commodities, we'll look a little deeper at BusinessWeek's article on commodities, "Amber Waves of Pain."