Commodity beta in a strategic asset allocation framework

According to Chepolis et al (2010), the global population has more than doubled in the last 50 years and is growing by more than 78 million a year. The world’s inhabitants currently number seven billion and estimates show that, by the end of 2030, this fi

The Standard & Poor’s Goldman Sachs Commodity Index (S&P GSCI) and the Dow Jones UBS Commodity Index (DJ UBSCI) are the two most liquid and widely used commodity indices in the global market. “We undertook to analyse the historical returns of these two indices and compare them against traditional asset classes in order to determine whether or not commodities can be viewed as a separate asset class. There are three predominant reasons for including commodities in the strategic asset allocation of a long-term investment portfolio, namely absolute return generation, diversification and inflation protection,” says Eugene Botha, head of research and portfolio manager at Momentum Manager of Managers.

Absolute returns

Many investors seek absolute returns from commodity investments if they anticipate that the demand for commodities will increase or the supply of commodities will fall.

Diversification

Diversification will not necessarily protect you against market risk. However, there is a historically low-to-negative correlation between commodities and other financial instruments, like shares and bonds, which suggests that commodities may perform well during neutral or negative years for shares and bonds.

Inflation protection

Shares and bonds characteristically perform weakly during times of high inflation, while commodities tend to perform well as they are closely related to price increases in essential goods.

According to Markowitz (1952), the investment goal of an institutional investor is to identify a set of portfolios that maximise the expected return for a given risk level, which he called ‘efficient portfolios’. Based on the risk tolerance of a specific investor, a portfolio with a distinctive set of allocated weightings is selected from the efficient set (generally shares, bonds and cash). To improve portfolios, institutional investors also explore the possibility of including alternative investments, such as commodities, in their portfolios.

Risk, however, can be defined very differently than the typical standard deviation or volatility as investors generally have certain goals in mind and very different risk tolerance levels. Analysing the relevance of commodity beta in a strategic asset allocation framework involved the following considerations:

• range of expected returns from the commodity indices

• risks associated with these indices

• ability to achieve real returns over time/inflation-protection characteristics

• diversification to other asset classes.

Looking at a snapshot of history and what the indices delivered from February 1991 to July 2012, both indices have delivered real returns in the region of 4% in rand terms.

Table 1: Risk and returns statistics of the DJ UBSCI and S&P GSCI adjusted for inflation in rands

Even though table 1 does show inflation-protection characteristics over an extended period of time and through various market cycles, it is also important to take care of the different characteristics over various time frames. From a risk perspective, these commodity indices do show extreme risk numbers from a drawdown and volatility perspective.

Looking at correlations at a specific point in time over a set period does have its biases and it is therefore worthwhile looking at various correlation metrics to gauge how correlations between asset classes change over time. However, both commodity indices show positive correlations to the global asset classes over a static, long-term period (which is largely affected by the currency effect). The high correlation to gold is two-fold, which also has a currency effect, but the mere fact that gold is a commodity also results in the correlation being quite high.

Table 2: DJ UBSCI TR (rands) versus S&P GSCI TR (rands) versus other asset classes (in rands) from January 1991 to July 2012

Compared with the other asset classes, there is a clear uncorrelated pattern of returns emerging over the longer term (see table 2).

The period of analysis is fairly short to make any concluding remarks on whether global commodity indices are a suitable uncorrelated source of return and should be included as a separate asset class.

“Investors could, however, still find commodities an attractive investment option as they provide diversification benefits and inflation protection. They also depict a different source of return and intuitively makes sense as the nature of commodities is very different to shares and bonds,” concludes Botha. “Choosing the right commodity beta for a specific objective of the longer-term investment portfolio is extremely important and needs to be chosen with care. Understanding the diversification within a commodity basket is also essential in order to have an informed view of what to expect from the return profile of the commodity beta over various market cycles.”