Tuesday, October 09, 2007

Advanced Portfolio Building III

Over the past week I have written a couple of posts on the topic of diversification and asset allocation. Today, I would like to discuss in a bit more detail a specific asset class that I am considering diversifying into: commodities.

For those readers who are not familiar with the concept of commodities, these are essentially the basic goods upon which the modern economy is built. They are typically divided into five categories: Energy, such as oil and natural gas; Industrial metals, such as copper and aluminium; Precious metals, such as gold, silver and platinum; Agricultural commodities, such as corn and wheat; and finally, livestock, such as live cattle.

Why diversify into commodities? The main reason is that, as explained in my previous post, commodities move independently of equity prices, or in more technical terms: the correlation between these two asset classes is close to zero.

While doing my research into the feasibility of commodity investing, I came across this informative article in the Journal of Financial Planning. One of the main points I wanted to research was the expected return of the commodity asset class. According to the article the average annual return of the Goldman Sachs Commodity Index (GSCI) between 1970 and 2006 was 11.5%. That is pretty impressive. Just as importantly, the commodity index seems to generate the highest returns in times of unexpected inflationary pressures. This means that while the rest of your asset classes may be suffering the twin scourges of inflation and high interest rates (which the Fed uses to combat inflation), investments in commodities tend to perform at their highest levels. For a more complete picture of the historical performance of this asset class, take a look at a chart of Dow Jones AIG Commodity Index (DJAIG).

The article offers a quantitative analysis of the diversification benefits offered by commodities. I will save you the suspense. According to the article a portfolio weight of 24% in commodities between 1970 and 2006 resulted in a a higher return compared to a portfolio of 60% stocks and 40% bonds; while simultaneoulsy reducing the volatility of the portfolio by 13.5%. That certainly gives me some food for thought.

Once again, it seems that the main issue is finding a good vehicle for investing in the commodities market. The article mentions two ETFs, GSG and DBC as funds worth considering, but both of these funds seem relatively new and don't offer enough of a track record for my taste.

I will do some more thinking on this topic. I am not quite ready to jump into that particular pool.

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