Craig Israelsen: Commodities Provide Good Diversification

There's a new study out by Professor Craig Israelsen at BYU that provides more good news about commodities as an asset class.

As a number of other reports have also done in recent years, it dismisses the notion that commodities should be viewed as some sort of a "No Go Zone" for individual investors. Instead, in this report, commodities are shown to provide good diversification for typical investment portfolios while boosting overall returns.

The original report is available at Index Universe and an interview with Professor Israelsen is up over at my new favorite website HAI (Hard Assets Investor):

From the interview:

Professor Craig Israelsen of Brigham Young University is emerging as an important voice in the asset allocation debate. The reason? He keeps things simple.

In a November/December 2007 article in the Journal of Indexes ("The Benefits Of Low Correlation"), Israelsen examined the performance of a simple portfolio built with combinations of up to seven different asset classes: large-cap U.S. equities, small-cap U.S. equities, non-U.S. equities, U.S. intermediate-term bonds, cash, REITs and commodities.

His conclusion? Only REITs and commodities added a major diversification benefit, and they deserve to be included in all portfolios ... including conservative retirement portfolios.

This is a particularly difficult subject for many individuals who are managing investment portfolios while in retirement because most people either think that commodities don't provide enough returns or that they are too volatile.

According to this study, which goes back 37 years, both of these claims are unfounded.

The most interesting part of the report (at least to me) is shown in the chart below - not so much the combination of adding REITs and commodities (as noted above), but the effect of just adding commodities.

First you start with an equally weighted six assets investment portfolio consisting of the following:

1. Large-cap U.S. equities
2. Small-cap U.S. equities
3. Non-U.S. equities
4. U.S. intermediate-term bonds
5. Cash
6. REITs

And then you add in commodities in the form of the GSCI Commodities Index. Note how the overall rate of return goes up slightly, but, more importantly, the worst years are much less severe.

As the seven assets portfolio was constructed, there were no periods with cumulative losses of 10 percent or worse, whereas for the six assets portfolio, these losses occurred up to 5 percent of the time. For a "stocks only" portfolio, losses of 10 percent or worse happened up to 14 percent of the time, depending on the mix of stocks.

This is a subject that doesn't get anywhere near the attention that it should - after one, two, or three years of losses, a lot of individual investors bail on their investment approaches, locking in those losses, as many did earlier in the decade.

More from Professor Israelsen:

I've recently updated the data on this study. Between 1970 and 2006, large-cap U.S. equities had about an 11% return. But there were eight years in that 37-year period where large-cap stocks had a negative return. Moreover, the worst 3-year cumulative return was about 38%, from 2000-2002.

Over that same time period, commodities had an average annual return of 11.5%. They had nine years with a loss, so one more than large-cap U.S. stocks. But the worst 3-year return for commodities was only 26% - much better than equities.

I think that surprises people. It runs up again the idea of commodities being risky investments.

It doesn't surprise me.

The returns get even better if you favor the asset class(es) that happen to be in a secular bull market and reduce your exposure to the one(s) in a secular bear market.

You can see the secular bulls and bears in the chart below using data from the report.

The period from 1966 to 1982 is generally considered a commodity bull/stock bear market, which was then followed by the opposite conditions from 1982 to 2000.

Since the turn of the century, despite what you may hear on CNBC, it's pretty clear that it has flipped back to commodity bull/stock bear.

What's striking in the chart above is how you can have a big up year or two during a bear market and a horrible year or two within a bull market. Also, the best six years of gains - 1973, 2000, 1972, 1999, 2007, 1974, 1989 - were all for commodities.

Unfortunately, by the time your typical retail investor embraces the whole idea of commodities as an important asset class - sometime in the next decade - the commodity bull market will probably be nearing its end.

Comments

[eric hart]

A timely and important article. By the time that this information becomes widely known, believed, and practiced, the commodity bull will be over.

Studies show that investors are slow to adapt to changing environments and new paradigms that conflict with what they think they know.

People that include a percentage of their portfolio to commodities will be better off on average over the next decade. Great article, thanks.

[JKC1967]

Excellent summary Tim. I actually read the same article over HAI a couple days ago (you're right, its a GREAT site), and you're article summarizes it nicely as well. You're six asset portfolio, minus the cash, is what I have in my son's 529 account for college, and reading this really made me think how great it'd be if 529 plan I am in added commodities as an investment!

[JKC1967]

One other question/comment: Have their ever been any studies done re: allocation to pure commodities, versus allocation to a sector equity index? Do the sector equity indexes capture the same effect as the pure commodities?