Are Oil Prices Off the Cliff?

Oil is in an intense bear market.  The price for U.S. West Texas Intermediate Crude hit $29.93 per barrel recently due to concern about lowered demand from China and the ongoing supply glut.  "...Standard Chartered said fund selling may not relent until it reaches $10."  This has affected the oil sector, OPEC and the oil producing countries and the prices of certain investment products such as MLPs and High Yield bonds.

Energy companies such as Exxon Mobil and Royal Dutch Petroleum have seen their stock prices slide.  The sector has been down 9% in the last 9 days of trading.  Others are cutting capital expenditures and workers.

Countries affected negatively by the price slump are Russia, Saudi Arabia and the OPEC nations and shale oil dependent states in the U.S.  These include Alaska, North Dakota, Oklahoma, Louisiana and New Mexico.

As always, there are some buyers trying to catch a falling knife.  Gary Bradshow, portfolio manager of Hodges Small Cap Fund, is buying natural gas firms in the belief that oil will rally to $55 per barrel.

The source for this article can be accessed here.

Gold: Is the Bubble Popping?

On Friday, May 17th, gold futures dropped to $1,358.30 per ounce;  retracing its steps from a high of $1,920 per ounce in September 2011.  Year to date, it has dropped about 18% on the COMEX in New York.  Money managers such as BlackRock, Northern Trust, Farallon Capital Management, Whitebox Advisers and Soros Fund Management have reduced or hedged against gold as represented by the exchange traded product:  SPDR Gold Trust.

BlackRock and Northern Trust sold more than 50% of their holdings and Soros Fund Management sold 12% as of March 31, 2013.  This follows a quarter where Soros Fund Management sold 55% of their gold position.  Whitebox Advisors sold 90% of their smaller position.  Farallon Capital Management used put options on the SPDR Gold Trust as their negative view.

On a high level, the number of short futures and options contracts on gold is growing.  According to EPFR Global of Cambridge, Massachusetts, $21.1 billion in gold and gold-related funds have been sold by investors.

On the other hand, Paulson & Company, Schroder Investment Management Group and Elliott Management have held onto or bought SPDR Gold Trust.  They are looking at increased demand from India and China as a catalyst for a recovery in the asset.

The source for this article can be accessed here.

Warehousing for a Commodities Trade

Traders from specialist commodities firms and, to a lesser extent, banks are buying warehouse in various port cities to store metals for "financing deals".  They buy metals from mining companies and sell it for delivery in the future.  This trade makes money when the market is in contango, when futures prices are higher than current (spot) prices.  The traders only have to ensure that storage costs are less than the profit from the trade.

The London Metals Exchange (LME) restricts how much metal can be shipped on a daily basis.  Meanwhile, buyers have to pay storage costs until they can be released.  Usually, metals manufacturing companies obtain their metals from producers using fixed long-term contacts.  If their business plan projections are too low, then they have to buy more on the market which has much higher prices than the LME.

For example, Pacorini Metals, a unit of commodity trader Glencore, has enough warehouses to store two million tons of aluminum - about 20% of the total stock.  Glencore will also buy 15.4 million tons of aluminum over the next seven years from Rusal, a Russian company.  There is an inherent conflict of interest that is being managed within the firms "Chinese Walls".  These firms have insight into one of the key pricing factors for the commodity, the amount of metals released as dictated by LME rules.  This gives them an edge when trading for their own accounts.  The LME is conducting a review of its processes.  Chief Executive Officer Martin Abbott believes that these warehouses are used primarily for "financing deals" and because the rate of delivery is low or because of the warehouse conflict of interest.

The source for this article can be accessed here.

Asset Allocation Trends in Public Pensions

In the October 1, 2012 issue of Pensions & Investments, I noticed an interesting statistic in an article about the funding ratios of public pension plans.  The weighted average asset allocation of the top 100 plans in Pensions & Investments' universe for 2011 is as follows:

• US Equities - 21.6%
• Global Equities - 16.9%
• International Equities - 13.2%
• Fixed Income - 23.9%
• Private Equity - 7.5%
• Real Estate - 6.3%
• Hedge Funds - 2.3%
• Real Return - 1.2%
• Commodities - 0.4%
• Cash/Other - 4.4%

The target allocation for the same year was as follows:

• US Equities - 15.7%
• Global Equities - 23.6%
• International Equities - 9.7%
• Fixed Income - 25.2%
• Private Equity - 7.3%
• Real Estate - 7.6%
• Hedge Funds - 2.8%
• Real Return - 1.6%
• Commodities - 0.6%
• Cash/Other - 2.9%

The weighted average asset allocation 2007 is as follows:

• US Equities - 36.5%
• Global Equities - 6.0%
• International Equities - 17.4%
• Fixed Income - 25.3%
• Private Equity - 5.2%
• Real Estate - 5.7%
• Hedge Funds - 0.9%
• Commodities - 0.2%
• Cash/Other - 2.8%

The biggest losers from 2007 to 2011 were US and International Equities.  Global Equities, Private Equity, Real Estate, Hedge Funds, Real Return and Commodities were net gainers.  Based on the target allocations, we can expect more investment in Global Equities, Real Estate, Hedge Funds, Real Return and Commodities.

The source for this article can be accessed here.

Hedge Funds Are Not An Asset Class

Capital Generation Partners (CGP), an investment advisory firm, analyzed portfolio diversification ideas.  They concluded that there are only three asset classes:  debt, cash and equity.  Alternative investments such as hedge funds should not be classified as an asset class.  They should be classified based on their underlying positions.  Hedge funds are merely investment strategies for these assets.  There are four strategies based on two points:  directional versus arbitrage and systematic versus discretionary.  These four strategies and three asset classes combine to create twelve buckets.

Equities
directional & discretionary - equity long/short, long only, real estate, private equity and 130/30 funds
directional & systematic - equity index trackers and quantitative funds
arbitrage & discretionary - equity market neutral and event/risk arbitrage
arbitrage & systematic - equity statistical arbitrage and systematic CTAs

Cash & Commodities
directional & discretionary - global macro, physical commodities and currency (carry) trading
directional & systematic - trend following CTAs, commodity ETFs and money market funds
arbitrage & discretionary - commodity/macro curve trading and volatility arbitrage
arbitrage & systematic - statistical arbitrage and systematic CTAs

Fixed Income
directional & discretionary - fixed income long/short and distressed debt
directional & systematic - bond indices
arbitrage & discretionary - global macro and structured credit
arbitrage & systematic - fixed income arbitrage and systematic CTAs

Proper diversification includes having non-correlated assets in a portfolio.  CGP analyzed returns from 2000 to 2010 for the twelve categories.  Their conclusions were:

• Alternative investments are not real diversifiers of a traditional equity/fixed income portfolio
• Hedge funds should be allocated across the twelve categories and not be treated as a separate asset class
• Fund managers should be closely monitored for style drift
• Correlation map indicates that larger allocations should be made to hedge funds

The correlation heat map from the paper confirms an earlier study by Welton Investment Management.  Global macro and managed futures (Barclays CTA Index in this case) are not correlated to other hedge fund strategies.  In CGP's chart, equity market neutral can be added.

The source for this article can be accessed here.

Farmland: the New Real Estate Investment

Institutional investors are becoming interested in a specialized real estate subsector:  farmland.  In today's low return market, its steady income plus appreciation has become attractive.  Looking at annualized returns for 1, 3, 5, 10 and 20 year periods (as of 12/31/2011), the income ranges from 6.59% to 7.90% while the appreciation returns 3.31% to 7.87%.  Total returns are from 9.9% to 14.88% according to the National Council of Real Estate Investment Fiduciaries (NCREIF).  In addition, agriculture has low correlations to other asset classes and is a hedge against inflation.

Some pension funds buying farmland in the past 1.5 years are Iowa Public Employees Retirement System ($100 million with UBS Agrivest), City of Alexandria (Va.) Fire and Police Officers Pension Fund ($5.5 million with Hancock Agricultural Investment Group), Oregon Public Employees Retirement Fund, the Los Angeles City Employees Retirement System and the Orange County (Calif.) Employees Retirement System.  Callan Associates, a consulting firm, has looked for farmland for investors eleven times in the past 1.5 years.  Between 2000 and 2010, they conducted one search.

To give you a frame of reference for the price appreciation of farmland, the NCREIF Farmland index's market value in the fourth quarter of 2006 was $1.4 billion.  In the fourth quarter of 2011, it was $29 billion - an increase of 107%.  The increase is driven by strong farmer profitability and competition for land.  It is not driven by the institutional investors coming into the real estate market.  The index only represents 1% to 2% of the $2 trillion in total farmland value.

The source for this article can be found here.

Regulated Hedge Funds: UCITS and Mutual Funds

SEI published a white paper on the growth of alternative investments called Regulated Alternative Funds: The New Conventional.  Because of the credit crisis of 2008 and the current Eurozone crisis, more and more investors have clamoring to be able to invest in alternative investments to lower downside volatility and offer returns uncorrelated with long-only mutual funds. In the first 8 months of 2011, $61 billion flowed into these investments. $22 billion (39% of all investment capital) were invested UCITS funds. There are now more than 1,500 UCITS funds managing $254 billion. $39 billion were invested through US mutual funds and ETFs. They now compose 4.4% of mutual fund assets and are growing at a 17% rate since 2007 when they were 2.2% of mutual fund assets. There are approximately 730 of them with 118 launched in 2011. Mutual fund families such as Ategris, BlackRock, PIMCO, Nuveen and First Eagle have funds that invest in traditional hedge fund strategies such as managed futures, long/short, credit, commodities, arbitrage and absolute return fixed income.

Internationally, they are constructed in an evolving vehicle known as Undertaking for Collective Investment in Transferable Securities (UCITS). Success has brought on investors. There are established funds with good returns, transparent investment and risk management strategies, and strong brands. The largest fund is the Standard Life Investments Global Absolute Return Strategies with $13.6 billion in assets under management. Other large funds include Julius Baer BF Absolute Return, Newton Real Return, JP Morgan Income Opportunity and PIMCO GIS Unconstrained Bond.

Within the US, they are launched within mutual fund families and ETFs. The largest are, in order of size, the SPR Gold Shares ETF, PIMCO Commodity Real Return Strategy, Ivy Asset Strategy, and iShares Silver and Gold Trusts. For investors, both structures offer more transparent risk management, liquidity, counter party diversification and limits on leverage. Investors are seeking better returns, lower volatility and to protect capital. Mutual fund families are aggressively marketing to and educating investors and registered investment advisors through white papers, instructional videos, fact sheets, regulatory filings and road shows.

Mutual funds are seeking to increase their fee structure. Alternative asset managers are seeking to have a more varied investor base.

When new products are launched, rules are reviewed. They are on the third iteration for UCITS. In the US, the SEC has stopped approving new funds and ETFs to review the effects of derivatives on portfolios. Within Europe, Luxembourg and Ireland are expecting to conform with UCITS regulations with the bonus of having additional flexibility. This may make them preferable to certain investment strategies and investors.

Demand is growing from sovereign wealth and national pension funds in Asia, Latin America and the Middle East and US institutional, high net worth and retail investors.

Institutional Investors Favor Emerging Markets and Alternative Investments

In an article published by Pensions & Investments, the Deutsche Bank 2011 Institutional Survey shows that investors are planning to shift their capital into the emerging markets and alternative investments (commodities, hedge funds, private equity and real estate) over the next year.  They will be moving out of the US stock and government bond markets.  The survey was conducted for 101 investors with $1.2 trillion in assets.

The source for the article can be accessed here.

Views on China: This Is What Makes Investing Interesting

China.  There is so much news about the country in the financial news.  We will pursue a couple of viewpoints in this post.  First is the article in the New York Times about China participating in the bailout of the Eurozone.  I hope China is smarter about it than the US Government in bailing out the banks in 2008.

In a post written by Burnham Banks at hedged.biz, China's GDP growth was 9.1% for the third quarter of 2011, well ahead of the 8% needed to keep stability in the county.  It is down from a previous figure of 9.5%.  However, inflation is rearing its ugly head.  In September, it was 6.1%.  If you look at its components, you see some worrisome numbers.  The price of food is up 13.4% with meat being up 28.4%.  The government has to walk a fine line between growth and inflation.

Managers of commodities funds are more positive since the September sell-off but are cautious about China's economic growth.  They believe that the government will loosen monetary policy later this year to keep growth at the 9.3% target.  Also, the drop in commodity prices is causing certain fund managers to see value in them, such as industrial metals and crude oil.  The source for this part of the article can be accessed here.

China perma-bear, Jim Chanos, says that the hard landing for China's economy has begun with troubles in its banks and real estate.  In a nationwide survey, home prices rose in less than 50% of seventy cities.  The number of home transactions has fallen 40% to 60% in the past two months when compared to last year.  But the performance of China's banks do not support his investment thesis.  Agricultural Bank of China, Industrial & Commercial Bank of China and Bank of Communications Co. reported huge gains in the third quarter.  Chanos' replied, "Western banks reported record profits in 2007 before collapsing."  Hard to argue with someone who shorted Enron in 2001, the homebuilders in 2007 and credit-related stocks in 2007.  However, we hear a lot about his successes.  What about his failures?  The source for this part of the article can be accessed here.

Being Bullish on Commodities

Hedge fund managers are optimistic about the commodity markets.  They accumulated more long positions by October 18th in 18 futures and options contacts.  The commodities with the biggest jump in contracts were heating oil, gasoline, coffee and soybeans.  The Standard & Poor's GSCI has been extremely volatile the last two months.  It is up 9.2% this month and was down 12% last month.  Managers are predicting that the emerging markets countries and the US will continue to grow.

Crude oil is up 15% in October.  Corn is up 9.9%.  Coffee has been up 22% for the year.

Nelson Louie, Global Head of Commodities at Credit Suisse Asset Management, said that the recent fluctuations in the markets were a result of traders deciding to increase or decrease their exposure to commodities based on the macroeconomic concerns.  Once they are resolved, then supply and demand should drive commodity prices.

The source for this article can be accessed here.

Gold: September Weakness Is Only Temporary

In early September, Gold hit a high of $1,920 per ounce.  It has since dropped to $1,655 per ounce as of October 7th.  Reuters asked the best performing commodities funds, as ranked by Lipper, about their forecasts for the metal for the rest of the year.

The fourth ranked manager, Paula Bujia of the Schroders Gold and Precious Metals Funds, bought only gold and midcap gold mining companies.  She is waiting for more selling of gold ETFs before adding to her positions.  Her choices for stocks are Randgold Resources, Yamana Gold and Eldorado.  They are predicted to have record earnings, increasing dividends and cash levels for their balance sheet.  However, until the markets return to a more normal state, their stocks will continue to be under pressure.

The third ranked fund manager, Kurt Hug of the Antares Precious Metals Funds, thought that gold and other commodities would rebound in the near future.  There are few other investments that investors can buy in a difficult market.

The top ranked fund is the LGT Dynamic Gold Fund.  Peter Sigg of LGT Capital Management said that they were slightly leveraged in gold's run-up to $1,920 and slightly invested in cash during the retreat.  He noted that in September 2008, gold prices fell in tandem with stocks and commodities and may do so in 2011.

The article can be accessed here.

Hedge Funds Are Down in the Third Quarter

Hedge funds lost 5.02% for the third quarter of 2011 according to research by Bank of America Merrill Lynch.  This is the largest decline since the third quarter of 2008 when they fell 9.48%.  Much of the losses were caused by the sell-off in August after US debt was downgraded and by the European debt crisis and commodity price collapse in September.  The stock markets have continued to fall in October.  Commodity Trading Advisors were even for September and they were the best performing hedge fund strategy. Equity long/short was down 4.76%.

On the other hand, Red Kite Capital Management's commodity fund is up 47% year to date benefiting from a large short position in copper.  It was up 19% in August and 17% in September.  The short position was established based on a contrarian idea that Chinese demand for copper would slow down.

Sources for this article can be accessed at Reuters and www.hedgeworld.com.

An Inflection Point for Gold?

Over the last two trading days, gold and silver futures have dropped by 9% and 25% respectively.  Up until recently, gold had been regarded as a safe haven investment.  As investors sold riskier securities, they bought US Treasuries and gold.  Now, gold is being treated as any other commodity.  In the last two weeks, gold has fallen in tandem with stock markets while the US dollar has risen.  There are a number of reasons for the change in investor psychology:  fear of a global recession, the Euro debt crisis, contents of the Federal Reserve's speech on Wednesday and hedge fund selling.  Funds were rumored to be taking profits from their gold positions, using them to raise cash for margin calls on other positions or raise money for possible investor redemptions.  In a replay of the credit crisis of 2008, funds sometimes have to sell what they can, not what they want.

Sources for this article can be found at www.hedgeworld.com and the New York Times.

CDO: Alternative Assets Being Used as Underlying Assets

CDOs were created to use bonds, mortgages and commercial loans as the underlying collateral.  In the last ten years, they have begun to use alternative assets such as distressed debt, hedge funds, commodities and private equity as the underlying.  They have also created CDOs with one tranche.

Distressed debt is defined as securities of companies in default or that are trading below investment grade.  They have a yield of the Treasury rate plus 10%.  The portfolio of the CDO may include both distressed and not distressed debt.  By the structure of the CDO, the rating of the senior tranche is higher than the underlying portfolio.  Investors can gain access to distressed debt and limit their risk.  Banks are the main sellers of distressed debt to CDOs.  It cuts their losses on the debt, offloads their liabilities to the CDOs and frees up reserve capital by reducing their nonperforming assets ratio.

Collateralized fund obligations (CFOs) have multiple hedge funds as the underlying assets.  The institutional investors interested in this vehicle are pension funds, insurance companies, mutual funds and high net worth clients.  The hedge funds are aggregated under a fund of fund manager.  The manager has restrictions on the total number of hedge funds, number of investment strategies and percentage invested in each fund.  The restrictions are set by the rating agency.  When the payments are due to the investors of the CFOs, the fund of fund manager has to notify the hedge fund managers to redeem the investments.

Commodities can be the underlying assets for collateralized commodity obligations (CCOs).  More accurately, the assets are Commodities Trigger Swaps (CTSs).  These transactions trigger a payment when a condition is met.  An example would be when the price of the commodity hits a price target.  The CTSs would be based on a basket of commodities.  They would avoid extremely volatile assets.  The trigger events would have to be substantially spread out to avoid multiple payouts at the same time.

Unlike normal CDOs, single tranche CDOs (STCDOs), also known as bespoke CDOs or CDOs on demand, only create one tranche.  They are structured as synthetic CDOs, using CDSs to receive premiums to pay the interest rate on the CDOs' securities.  In this security, the investors have more control over the terms than in a CDO with multiple tranches and receive all cash flows.  The advantage for the sellers is that they are cheaper and quicker to issue.  In a normal CDO, the entire risk of the portfolio is transferred to the investors.  In a STCDOs, only a specific portion of the portfolio risk is transferred to the investors.  The seller is still exposed to the underlying assets in this case.

CDO squared invests in other CDOs.  This allows for more diversification and higher spread returns for the investor.  Losses are incurred based on where (the tranche) bond defaults occur.  In a normal CDO, losses are incurred based on the number of bond defaults.  CDO squared may be cash backed or synthetically created and may invest in different tranches or specialize in one tranche across multiple CDOs.  There is a danger that the CDO squared may invest in assets that are in multiple CDOs.  Rather than diversifying the portfolio, these overlapping assets cause the portfolio to be concentrated in them.  This would cause greater losses than expected if the underlying assets default.

Lastly, there also was a CDO created with private equity investments as the underlying assets.  As with CFOs, there were restrictions on the total number of private equity managers.

ETFs That Replicate Hedge Fund Strategies

Murray Coleman of Barron's wrote about ETFs that gave the investor exposure to hedge fund strategies without paying to 2 and 20 fee or being a qualified institutional buyer.  The ETFs named in the article were Cambria Global Tactical ETF (GTAA), Credit Suisse Long/Short Liquid ETN (CSLS), Credit Suisse Merger Arbitrage Liquid ETN (CSMA) and WisdomTree Managed Futures (WDTI).

CSLS tracks hedge funds using long/short strategies and CSMA does the same for merger arbitrage funds.  GTAA holds about 80 ETFs in its portfolio and the fund managers change its allocations among them depending on the current investing environment.  WDTI invests in 24 futures in about 12 sectors.  It invests using the seven month moving average as an indicator of which contracts to short and go long.

The source for this post can be accessed here.

Commodity Funds: Best Performers for the Second Quarter

There was a sell-off in commodities in early May causing the average commodity fund to fall 5.12% for the second quarter.  The best commodity fund was up 6.8% in the same timeframe.  Obviously, it was a short fund - PIMCO's CommodityPLUS Short Strategy.  This fund bases its portfolio on the Dow Jones - UBS Commodity Index and takes the opposite side of the trade.  Other strong performers were gold and market neutral funds.  In fact, seven of the top ten best performers of the quarter were gold funds.  They invest in gold buillion, futures and miners.

The source for this post can be accessed here.

Managed Futures Are Predicting Stock Market Downturn

Managed futures funds are run by Commodity Trading Advisers that use predominantly use trend following trading strategies.  The charts of the Barclay and Newedge CTA indices are predicting a downturn in equities in the near term.  After the Barclay CTA Index traded in a range in 1999-2000 and 2006-2007, the Standard & Poor's 500 Index collapsed.  There was another period in 2009-2010 and the market has been trending down.  Looking at the daily Newedge CTA Index chart, there was a recent drop of 5%.  This is presaging a drop in equities.

The source for this article written by Thomas Lott, President of Potomac Portfolios, with charts, can be found here.

Return Components of Commodities

At times, I have referred to terms before defining them in this blog.  This happened in an earlier post about commodities.  Returns for commodities are composed of the spot return, the roll return and collateral interest.  The spot return is the percentage change in spot prices of the commodity.  As commodity futures approach their expiration date, investors sell them and buy futures contracts that have a later expiration date.  This is called rolling their positions.  The gain or loss is the change in the prices of the contracts.  If the commodity forward curve is sloping downward i.e. contracts with a later expiration date are less expensive, then the market is in backwardation.  If the contracts with a later expiration date are more expensive, then the market is in contango.  To establish a futures position, the investor has to put a small amount of margin - usually 5% to 15%.  This varies depending on the commodity contract.  The remaining cash is invested in Treasury bills, TIPS, money markets and other, safe, liquid assets and used for collateral for the remainder of the position.  The interest earned on these assets is the collateral interest.  Commodity futures have a implicit leverage due to the structure of the markets.  In addition, an investor can apply another layer of leverage by borrowing money to establish the position.

Protecting a Portfolio Against Inflation

I was directed to a research report written by AllianceBernstein about how an investor can prevent inflation from eating into real returns for a target date fund.  Target date funds are a relatively new asset allocation product that adjusts the percentages of each asset during the length of the investment.  This is called the glide path.  The asset mix is higher for riskier assets (i.e. equities) early.  As time goes by, the asset mix becomes more conservative with a heavier weighting in bonds as the fund approaches its target date.  Although the paper was written for target date funds specifically, it can be applied to any traditional portfolio.

Spikes in inflation can be considered a rare tail risk event (three times since World War I).  When it happens, they reduce the value of investment portfolios considerably.  Once the spike is identified as such, buying any protection skyrockets.  The addition of real assets can serve as a hedge against this event.

AllianceBernstein considers three factors when analyzing hedges:  sensitivity to inflation, reliability and cost-effectiveness.  The sensitivity is how an asset reacts to inflation.  Equities has a -2.4 sensitivity.  When inflation is up 1%, equities fall 2.4%.  20 Year Treasury bonds have a -3.1 sensitivity.  Treasury Inflation Protected Securities (TIPS) have a sensitivity of 0.3 to 0.8, depending on the duration of the bond.  Commodity futures have a sensitivity of 6.5.  The second factor, reliability, tells how often the sensitivity factor is correct.  For example, commodity futures have a reliability factor of 54%.  When inflation rises, then the futures may rise but it only does so half the time.  The chart shows that TIPS are the most reliable, then commodity stocks, REITS and commodity futures.  Buying these assets have an opportunity cost.  The investor is giving up returns to buy this insurance against inflation.

Here is a list of hedging assets:

• Equities - natural resource and real estate sectors
• Commodity futures
• Currency forwards
• Real Estate
• Gold
• Short term bonds
• TIPS

The report recommends a portfolio of commodity futures, equities and currency forwards.  The weight depends on the lifecycle of the investor.  Of the investor is still working, it should be about 5%-15%.  At retirement, 15%-35%.  After 10 years of retirement, 30%-50%.

Commodities: Futures vs. Equities of Natural Resource Companies

In an earlier post, one of methods of investing in commodities is to buy stocks in companies that buy, sell or produce them.  A research paper written by RS Investments of San Francisco, California suggests that having an equity position in these companies is better for portfolio diversification, a better hedge against inflation and will have a higher return than commodities.

From 1970 to 1999, commodities as an investment was negatively correlated versus equities, provided protection against inflation and performed the same as equities.  This caused investments in commodities to increase from $15 to $354 billion from 2001 to 2010 as investors sought after improved risk-adjusted returns.  During this timeframe, commodities became more correlated with equities and had worse returns.  The article shows a chart with the correlation statistics for the Standard & Poor's Goldman Sachs Commodity Index (GSCI) and the MSCI World Index.   In the last five years, it has risen to 0.60 and is slightly higher, 0.64, during down markets.  For example, if the market has a 10% up move, then commodities will have a 6% up move.  In the last three major downturns in the stock market (1998, 2001 and 2008-9), commodities have negative returns too.  Contrast that with the bear markets from 1970 to 1990, commodities actually had positive returns.

From 2001 to 2010, equity indices in natural resources companies outperformed commodity indices.  The paper believes that this will continue because one of the return components of commodities has been affected negatively by the commodity futures curve.  The return is generated by the changes in the spot (current) price of the commodity, the roll yield and interest on collateral posted when buying futures contracts.  (These terms will be more fully defined in a later post.)

Both asset classes had high correlation with inflation.

A study on portfolio performance was done based on an 85%/15% equities to commodities/natural resource equities allocation.  Every portfolio with the 15% natural resource equities position had higher returns and lower volatility compared to the equity/commodities portfolio.

The author of the study is RS Investments and the paper can be found here or here.