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How Commodities Affect a Portfolio

On Monday, we discussed some of the issues being raised about investing in commodities. However, much of the debate is centered on the performance on commodities investments by themselves. As we've discussed before, one should never make the mistake of thinking about an investment in isolation. Instead, one should consider how the addition of an asset impacts the risk and return of the portfolio.

With that in mind, we'll look at the individual returns and standard deviations of two commodity indexes -- the Dow Jones-UBS Commodity Index and the S&P GSCI Commodity Index -- and similar data for the S&P 500 Index and Five-Year Treasury Notes. We'll then look at the returns of typical 60 percent equity/40 percent fixed income portfolios, with and without a 5 percent allocation to commodities. (The allocation to commodities is taken from the equity portion.) We will look at both five- and 10-year periods ending June 2010. Portfolios are rebalanced annually.

July 2000-
June 2010

Annualized Return (%)

Annual Standard Deviation (%)

Dow Jones-UBS Commodity Index

7.3

23.1

S&P GSCI Commodity Index

7.0

35.1

S&P 500 Index

-0.3

16.7

Five-Year Treasury Notes

6.4

4.9

60% S&P 500
40% Five-Year Treasury

2.0

9.1

55% S&P 500
5% DJ-UBS
40% Five-Year Treasury Note

2.4

8.9

55% S&P 500
5% S&P GSCI
40% Five-Year Treasury Note

2.4

9.0

July 2005-
June 2010

Annualized Return (%)

Annual Standard Deviation (%)

Dow Jones-UBS Commodity Index

-1.3

32.5

S&P GSCI Commodity Index

-8.1

49.3

S&P 500 Index

-0.8

20.0

Five-Year Treasury Notes

5.7

4.7

60% S&P 500
40% Five-Year Treasury

2.3

11.5

55% S&P 500
5% DJ-UBS
40% Five-Year Treasury

2.4

11.3

55% S&P 500
5% S&P GSCI
40% Five-Year Treasury

2.4

11.1

As you can see, the portfolios that included a 5 percent allocation to either commodity index outperformed. Not only that, but the five-year period ending in June 2010 saw both commodity indexes underperform the equity allocation it replaced, and did so with much higher volatility. This was because of the low correlation of commodities to both stocks and bonds and the high volatility of commodities.

Tomorrow, we'll examine how commodities did in years when stocks or bonds had negative returns.

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