It is widely known among investment professionals that the Dow Jones-AIG Commodity Index (“DJP”) is an excellent complement to any portfolio. This index is comprised of a wide variety of commodities that are currently traded on the U.S exchanges. The following sub-indexes of the DJ-AGI are represented by the major commodity sectors within the broad index: Energy, Petroleum, Precious Metals, Industrial Metals, Grains, Livestock, Softs, Agriculture and ExEnergy. Thus, the DJ-AGI is a broadly diversified index across various sectors that in effect will smooth out the volatility risk and risk-return payoff (Sharpe Ratio), as opposed to investing in a single commodity sector.
In terms of portfolio diversification, it is academically and statistically proven that the DJ-AGI is quite beneficial to any portfolio/investor. When the DJ-AGI is added to a balanced portfolio of equities and bonds, the Sharpe Ratio will increase due to the DJ-AGI having a similar volatility to the S&P 500, as well as higher returns than bonds. The exposure and diversification in commodities along with reducing a portfolio's market risk and increased returns comparable to bonds will create an outstanding complement to any portfolio.
The advantages of adding the DJP to a portfolio can be further enhanced by adding ConocoPhillips (NYSE:COP). As shown below, ConocoPhillips is closely correlated with the DJP. In my view, this correlation can be exploited by holding COP instead of the DJP for diversification in the commodity sector. One key advantage is the annual yield that COP offers. COP is currently yielding 3.40% as of the close on Tuesday January 6, 2009. The difference in yield between COP (3.4%) vs. DJP (0%) can benefit investors greatly by offering an additional source of income – especially in depressed markets. Another advantage of COP is the outperformance relative to the S&P 500 over the past two years.
Even during the worst sell-off since the Great Depression, the outperformance to date further illustrates why COP is a great way to increase alpha and decrease market risk relative to the S&P 500. Lastly, the three oil giants, Exxon Mobil (NYSE:XOM), Chevron Corp. (NYSE:CVX) and ConocoPhillips (COP) have been trading in close tandem/correlation over the past two years until May 2008.
In May 2008, XOM drifted to the downside leaving COP and CVX still highly correlated. Then in October 2008, XOM became re-correlated with CVX and this time COP drifted further to the downside. As of yesterday's close, COP has remained in a trading range since its low in November. On the other hand, XOM and CVX have continued to trade higher in close correlation with one another, leaving COP behind. With this being said, I believe that COP could eventually trade alongside XOM and CVX again, which leads to greater upside potential to be achieved by owning COP.
Thus ConocoPhillips is an excellent way to diversify a portfolio as an alternative to owning the DJ-AIG Index, as well as the additional income being produced from dividends. In addition, the upside potential (stock price) and the probability that COP will once again trade in correlation with XOM and CVX is probable due to their trading history. Also, if you like whale watching – Warren Buffett has been adding to his already healthy position in ConocoPhillips. Is this a co-incidence?
For more information on the DJ-AIG Index see here. Information from the aforementioned website was used in this article.
Disclosure: Author holds positions in COP, BRK.B