Do we really need a commodities fund?
Pimco’s Greer: Investors can shoulder more exposure to risky asset
By Jonathan Burton, MarketWatch
Last Update: 7:55 PM ET Aug 8, 2006
Resource: Strategic Asset Allocation and Commodities
SAN FRANCISCO (MarketWatch) — How much of your investment portfolio should be in commodities? A lot more than you might think.
Why and how to invest in commodities is fairly straightforward. Commodities diversify the risk of holding stocks, bonds and cash. Exposure is simple through mutual funds and index-tracking exchange-traded funds such as iShares GSCI Commodity-Indexed Trust. Other funds like Oppenheimer Real Asset Fund and Pimco CommodityRealReturn Strategy Fund try to outdo an index.
Investors are generally advised to keep about 5% of a portfolio in commodities. But Bob Greer, a senior vice president at Pacific Investment Management Co., or Pimco, says that’s the bare minimum.
Greer, a pioneer in developing commodities into a mainstream asset class, points to a new study from research firm Ibbotson Associates commissioned by Pimco that shows even risk-averse investors can optimize portfolio performance by doubling — or more — their allocation to this often maligned sector. In an interview with MarketWatch’s Jonathan Burton, Greer talked about how to accommodate commodities in your investing strategy.
MarketWatch: For many investors, commodities are speculative and risky. Why does the Ibbotson study conclude that committing more money to this area is better?
Greer: We felt the industry did not have a very in-depth independent analysis of how much to invest in commodities. While we commissioned the study, the conclusions are Ibbotson’s.
The conclusions are that even in a portfolio that wants very little risk, a bit of commodities will allow that portfolio to have even less volatility. And the desired commodity exposure for moderate-risk portfolios was more than most people actually use. That moderate risk portfolio still wanted a little over 10% in commodities. Even the low-risk investor would want anywhere from 5% to 8% commodity exposure.
That does not mean we expect investors to put 10% or more commodities in their portfolios. Rather, for investors who use less than 10%, it should make them comfortable that they are doing the right thing; that the amount they are investing — which typically for most investors is around 5% — is not going overboard.
How does adding commodities to a portfolio reduce volatility?
Portfolio diversification is the primary benefit — exposure to long-only commodity futures positions on a fully collateralized basis. That type of investment has typically provided diversification from stocks and bonds, it has provided protection from inflation — especially unexpected inflation — and it has had returns comparable to equities.
The reason for that is you’re exposed to commodity futures prices. Changes in those prices reflect changing expectations about future supply and demand for commodities. Factors that change expectations — a weather event in the Midwest or a strike in a copper mine in Chile — typically don’t have anything to do with stock and bond markets.
Remember, you’re not buying commodities because you expect prices to go up. You’re buying commodities because you don’t know if commodity prices or stock prices or bond prices are going to go up or down.
But the diversification you describe comes from a commodities index, like Pimco uses. Can’t investors get the same benefit from commodity-related stocks?
When you invest in the equity of commodity producers, you’re investing in the management talent and the financial structure of those companies. Management, for very good business reasons, might be hedging production, in which case you don’t get the full benefit of changes in commodity prices. That’s why the equity of commodity producers has historically been more highly related to the stock market than the price of the specific commodity they produce. And you are not getting near the diversification benefit that you would if you used a commodity index.
Most of the indexes have exposure to a diversified set of commodities that include energy products, industrial metals, precious metals, grains, livestock, food and fiber, mixed in varying proportions. Commodities historically have enabled investors to use tremendous leverage. The nice thing about a commodity index is that it takes leverage out and you’re left with an index that is no more volatile than the Standard & Poor’s 500
The reason is that while an individual commodity price may be volatile, you mix it with commodity prices that are not highly correlated with each other, and the total index volatility becomes less.
Once you decide to invest in commodities, what’s the best approach?
An investor needs to make three primary decisions: One, which index do I want to track? Two, remembering that an index represents fully collateralized investment, what kind of collateral do I want to back my commodity futures exposure? For example, the published indexes assume that your collateral is in Treasury bills. However, it is possible to have Treasury Inflation-Protected Securities backing futures exposure. Three, do I want active management, either of the collateral itself or the commodity futures exposure?
Commodities have enjoyed a tremendous run. Isn’t an investment now coming late in the game?
There’s no doubt you would feel better if you had invested in commodities two years ago, just as you’d feel better if you’d gotten out of equities in early 2000. But the primary reason for commodities is diversification.
Given that your exposure is to expected future commodity prices — because we’re using commodities futures contracts — then we don’t know if surprises will be to the upside or the downside. Remember, you’re not buying commodities because you expect prices to go up. You’re buying commodities because you don’t know if commodity prices or stock prices or bond prices are going to go up or down.
End of Story
Jonathan Burton is MarketWatch’s investments editor, based in San Francisco.
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