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With all of the volatility we’re seeing in 2008, this is one of those times when investors really value assets that are not correlated to the broader markets.

That explains much of the current interest in commodities – investors are looking for ways to protect themselves through diversification.

Investments in commodities are expected to exceed $200 billion this year, according to Barclays Capital. That compares to $178 billion in 2007.

Barclays surveyed 260 institutional investors at a conference last week and found that about a third of them plan to have more than 10 percent of their portfolios in commodities in the next three years, despite prices that are at or near record levels. That number is up from about 20 percent in 2007.

More than half of these institutional investors say portfolio diversification is their main interest in commodities.

The results of Barclays’ survey track with the news that CalPERS, the giant California public pension fund, may increase its commodities exposure to as much as $7.2 billion through 2010.

Several years ago, we wrote an article explaining the role that hard assets can play in portfolio diversification. Hard assets increased overall returns while lowering or maintaining volatility in several sample portfolios. And we recommended giving investment portfolios a proper weighting in hard assets and rebalancing at regular intervals.

That article cited a study by Ibbotson & Associates that found very low correlation between hard assets and four other asset classes from 1970 to 1998 – U.S. large-cap stocks, U.S. small-cap stocks, international stocks and Treasury bonds.

Table 1

We looked at the same asset classes for the past 10 years, and as you can see on Table 1 above, the story really hasn’t changed much.

As you read across the line for hard assets (as measured by the S&P GSCI Index (NYSEARCA:GSG)), you can see that there is virtually no correlation with large-cap stocks (S&P 500 Index (NYSEARCA:SPY)) and Treasury bonds (Merrill Lynch U.S. Government Index). And for small-cap stocks (Russell 2000 Index (NYSEARCA:IWM)) and international stocks (MSCI EAFE Index (NYSEARCA:EFA)), the correlation is very low.

By comparison, look at the high correlation between large-caps and international stocks – these two asset classes moved in the same direction 82 percent of the time during the past 10 years. International stocks and small-caps correlated 73 percent of the time, and large- and small-caps moved together 75 percent of the time. Thus, a portfolio split between these three asset classes offered relatively little diversification to protect investors from market risk.

For the 1970-1998 period, commodities had a compounded annual return of 8.6 percent, according to Ibbotson. This was 4 to 5 percentage points below the annualized return for all three of the equity asset classes.

Hard assets, however, turned in a much stronger performance – both in absolute and relative terms - for the latest 10 - year period, as you can see in Table 2 below (click to enlarge image).

Table 2

Commodities as an asset class have handily outperformed the other four asset classes during this latest 10-year period, posting a compound annual return of 11.4 percent. Large-cap U.S. stocks lagged hard assets by more than 7 percentage points on average; the difference was more than 6 percentage points for small-caps and nearly 5 percentage points for international stocks.

We have long suggested that investors consider a portfolio diversification model based on the best-selling book “Asset Allocation: Balancing Financial Risk” by Roger Gibson. He recommends an equal allocation between domestic equities, international equities, fixed-income instruments and hard assets (precious metals, industrial metals, real estate and other tangible assets), with periodic rebalancing.

This model of 25 percent allocation to each of these four asset classes is on the bottom line of Table 2 (in this example, domestic equities are equally split between large-cap and small-cap stocks). You can see that a portfolio with this weighting in commodities generated a significantly better return than one with only stocks and bonds.

And looking at the standard deviation column above, the equal-allocation model was also much less volatile than any of the asset classes on its own, save Treasury bonds. This clearly shows the power of diversification in structuring a portfolio to balance return and risk.

Disclosure: No clients of U.S. Global Investors held any of the securities mentioned in this article as of December 31, 2007.

Source: Balancing a Portfolio with Commodities