Asset Allocation Expert Says Go Big on Commodities

Albert Brenner is the executive managing editor of Asset Allocation Parametrics, a firm that provides asset allocation advice to small institutions. Over the past few years, he's come to recommend significant commodities exposure to most of his clients ... if he can convince them to follow his advice.

HardAssetsInvestor.com (HAI): What is Asset Allocation Parametrics and how do you work with clients?

Albert Brenner, executive managing editor, Asset Allocation Parametrics (Brenner): This company grew out of my experience in the banking and nonprofit world; in particular, with regard to endowment management. It was hard to come by professional asset allocation guidance that was independent and not linked with a commitment to place money with a particular firm or organization.

It's either hard to come by or very expensive. There are shops like Cambridge Associates that do a wonderful job for clients, but if you are an organization with a $10 million or $20 million endowment, Cambridge Associates is completely out of your budget.

I was working for a prep school with an endowment of less than $20 million. At the time, we had the endowment split among three different firms. As we looked at the combined portfolio, we saw that managers were duplicating positions in certain stocks, so we weren't getting the diversification we needed.

As we started looking for guidance on how to better manage things, I was disappointed with the suggestions we received. I hold a CFA charter and I know what sort of technical guidance they should have been bringing to the table. They weren't bringing it.

HAI: So today, if a client approaches Asset Allocation Parametrics, what do you provide?

Brenner: We started initially publishing a newsletter on a quarterly basis to try to give people an idea on how they should be optimizing their portfolio. We're making a change to publish on a Web site, as that's more efficient and fits the audience.

When we started doing the modeling for portfolios, we initially had 16 asset classes. Actually, commodities were not one of them, because we did not have the data available at that time. We subsequently got that information and now we incorporate commodities as a standard asset class in our portfolios. Our portfolio optimization runs consistently show that commodities are a very useful asset class, providing great diversification benefits.

HAI: What is the range of commodities exposure you recommend to clients?

Brenner: That depends upon their particular risk position. But, to give you an example, one of the clients we advise is an arts organization in New York City. When we ran our portfolio optimization based on their risk tolerance, our recommendation to them was that they make a 20% allocation to commodities.

That was actually a little bit more than they had a stomach for. They initially agreed to a 12% allocation, and with the strong performance of commodities, that's grown to approximately 15%. That particular position has helped that portfolio weather the market over the course of the past 10 months, and I think it'd be fair to say that the trustees of that organization are quite happy with how they've done.

HAI: Is that typical? Do institutions shy away from making large allocations to commodities?

Brenner: Yes, I think so. I can't speak for a wide universe here, but I will say there is an aversion to the proposed riskiness of commodities. I can go through a full presentation to the board of an endowment, talk about the notion of mean variance optimization and correlations and how adding a risky asset to a portfolio can actually make that portfolio less risky as a whole. But when I get to the specifics of how they should allocate the portfolio, they balk at asset classes that are out of the ordinary, like commodities.

People aren't always rational. Just because a person feels more comfortable driving across the country compared to flying, that doesn't mean it's actually safer. You have to inform people's risk appetites.

HAI: How do you recommend people gain access to the commodities market?

Brenner: It's based on the work of Gary Gorton and Geert Rouwenhorst. The specific recommendation is to use a fully collateralized, passively managed total return index fund. That's the vehicle that we use in our portfolios. There are a couple of ways investors can access this market, including the iShares S&P GSCI Total Return Commodity Index ETF (GSG).

HAI: Are you concerned that there's a bubble in the commodities market?

Brenner: Any savvy investor should be concerned about the extent to which capital flows into an asset class may change the historical trends of how that asset class has performed. In our simulations, we use a lower return expectation going forward than what historical returns would warrant, precisely to discount that effect. Specifically, we model that the fully indexed total return will only be 4% over T-bill returns. We're not expecting really robust returns. But even with that modest level of returns expectations, we end up with optimal portfolios with 5%, 10% or even 15% or higher allocations to commodities.

The reason is the historical negative correlations. That's why commodities are a positive contributor even to low-risk portfolios.

HAI: What other asset classes do you look at?

Brenner: We look at a wide array of asset classes. Our models call for people to buy asset classes through passively managed mutual funds and index funds. In terms of domestic equities, we have large-cap and small-cap allocations. For specific clients, we'll also look at growth and value. Internationally, we look at U.K. equities, Japanese equities, European equities and emerging markets. We also look at venture capital, real estate, Treasuries (short, intermediate and long term), investment-grade corporate, high-yield corporate, TIPS, mortgage-backed securities, international investment-grade bonds and emerging markets sovereign debt.

HAI: What about gold bullion?

Brenner: No, I have not done that. It's something I should look at.

HAI: Any final thoughts on the role that commodities have to play in an asset allocation model?

Brenner: Nothing other than the fact that historical performance shows that commodities can be a good contributor to diversification and to risk reduction, perhaps contrary to what people's initial expectation may be. And surprisingly, of course, with what's happened over the last year: Commodities have also been a great contributor to returns - although their inclusion in our portfolio is more for risk amelioration than the expectation that it will increase returns. Even if you use relatively low expected returns, you still get high allocations to commodities in our optimization runs.