Craig Israelsen: An Alternative To Alternatives

Posted by Drizzt
November 25, 2007

Craig Israelsen says you can gain commodities exposure without the risk or the expense of a futures account.

Craig Israelsen is one of the foremost academics in the field of indexes and passive investing. A professor at Brigham Young University and a regular contributor to both Financial Planning and the Journal of Indexes, Israelsen recently wrote an article that tackled one of the most controversial topics in commodities investing: whether investors are better off owning commodity stocks or commodity futures.

Specifically, the article considered whether investors could swap exposure to the S&P GSCI commodities futures index for similar exposure to commodity-like stocks. Noting that the S&P GSCI was composed 70 percent of energy exposure and 14 percent metals, Israelsen wondered if you could combine an energy sector fund and a precious metals sector fund and achieve the same type of returns.

He recently spoke with the editors of HardAssetsInvestor.com to discuss his study and his findings.

HardAssetsInvestor.com (HAI): What drove you to create this “quasi-commodities” portfolio, as you call it?

Craig Israelsen (Israelsen): What motivated me to look at this was that these commodity funds use complex strategies, and complexity is not always a virtue. Complex strategies cost money and can melt down upon implementation. These funds use derivatives and structured notes, and they’re simply not as straightforward as traditional mutual funds.

The Rogers commodity fund was even frozen for a while following the Refco bankruptcy. You don’t see an S&P 500 equity fund having its assets frozen. Oppenheimer’s commodities fund also had logistical problems last year.

Goldman Sachs has been calculating the GSCI since 1970. You have to ask yourself: why haven’t there been products mimicking it until recently? If it’s a good idea, why didn’t they do it a while ago? The answer is that it’s hard to implement, and to get it into a product that’s not too expensive. What’s changed about our markets to make that possible today? Are our markets that much more advanced? I don’t know, but it’s enough of a question in my mind that investigating an alternative seemed like it was worth doing.

HAI: What exactly did you find in the study?

Israelsen: When you look at the GSCI, as of June, it was about 70 percent in energy. So, instead of investing that money in a commodities fund, you could take your money and invest it in an energy sector fund.

And between industrial metals and precious metals, that’s about 14 percent of the S&P GSCI. So you can take that money and invest it in a precious metals equity fund. And now you are up over 80 percent of exposure.

And you also could consider real estate equities as another “alternative” asset.

You know that stocks and the futures are going to perform differently, but you also know that the equity funds will have some advantages. For instance, you may gain some cost savings through expenses that tend to be lower in well-established sector funds. Commodities funds are typically not the cheapest funds around, with expense ratios in the 75-240 basis point range. Stock funds are usually much cheaper.

HAI: And did it work? Did you get similar performance?

Israelsen: The primary thing you obtain in commodities is very low correlation to equities – basically, you want the commodities to act as a cushion in the portfolio during difficult times. Generally, I found that incorporating these sector fund-based alternatives (energy, metals, and real estate) into aggressive portfolios boosted returns and lowered the worst one-year drawdowns compared to the same aggressive portfolios with a similar allocation to commodities. In safer, retirement-style portfolios, the three “quasi-commodity” sector fund approach increased the risk somewhat. But overall, the three quasi-commodity sector funds filled a similar service as commodities themselves.

The advantage of using sector funds, beyond the points I outlined above, is that you have the ability to finesse the focus of your “commodity-like” exposure. In other words, rather than a 70% allocation to energy which the GSCI has, you might equally weight energy, metals, and real estate when using sector funds. This suggests that an investor is actively managing their passive assets, but the sector approach does make it possible.

HAI: There is certainly a lot of discussion about the different allocations between different commodity indexes.

Israelsen: Right, and with the sector equity funds, you can fine-tune that. The truth is, commodities funds are often gauged after indexes, but can we honestly say that the GSCI is a passively managed index? No, I don’t think so. I would argue that a commodities index is a fairly actively managed index, and even if an investor chooses to invest in a commodities fund that tracks an index, well, they’re still going to have to live with the fact that the index is being actively managed in a sense, and they might prefer different exposure. If you’ve already admitted that your commodities fund is active, then you should ask, how actively do I want to manage that part of my portfolio. Do I want more control at the individual asset level?

HAI: How much exposure should an investor have to commodities and alternative asset classes?

Israelsen: Both sector funds and commodities are like Tabasco sauce: they are meant to be a small ingredient in a larger recipe. In terms of actual numbers, a portfolio allocation of 10-15 percent in commodities or quasi-commodities is very helpful in smoothing the performance of the overall portfolio. I wouldn’t recommend salsa with 15 percent Tabasco!

Related posts:

  1. Do we really need a commodities fund?
  2. Hidden Commodities Exposure
  3. Adding Alternatives to your allocation
  4. CFTC is going to clamp down on oil speculators
  5. DBA Is Full-Up
ETF, Gold & Commodities

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