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Using Commodities to Lower Volatility

Updated on October 14, 2014

Lowering Portfolio Volatility

In the course of building a long term investment portfolio, the focus should be based on not just returns...but risk adjusted returns. The premise behind a multi asset portfolio is the combining of multiple asset classes in which each produces a positive long term return, but are not always highly correlated can produce more consistent longer term returns...while offering a lower overall degree of portfolio volatility. One of these asset classes is the commodities market.

Commodities independently have historically been more volatile than stocks with a higher standard deviation of returns over the last 40 plus years. Since 1970, US large cap equities have posted a standard deviation of 17.63 versus 24.29 in the GSCI commodity index. However, when combined as a component in an overall asset allocation...they can serve an important role. All too often investors chase after the most recent top performing assets. Using commodities as an example, the last 5 years have been less favorable as the US and most of the developed world has seen a somewhat anemic economic recovery from the 2008 recession. Yet, if we were to examine average returns of the broad based commodities market in comparison to the US large cap stock market, we find that the average returns are not much different. During the period of 1970 thru 2013…US large cap equities posted average annual returns of 10.41%, while commodities posted average annual returns of 9.21%.

What is important to note by looking at the following chart on is the individual year over year returns. What we find is that in many years in which stocks suffered...commodities offered a cushion to portfolio returns. In many years the inverse was also true. During periods of extraordinary deflationary panics such as 1929 or 2008, asset classes often become highly correlated. However, we also find that in years like 2002 as the tech bubble had imploded and the US was recovering from the events of Sept 11th...commodities offered a substantial reduction in overall portfolio volatility.

It is also important to recognize that a proper investment asset allocation is defined by multiple asset classes and sub-asset classes of satellite investments to compliment core holdings like US large cap stocks. Commodity holdings are just one such holding. As a result of the high volatility that accompanies a broad basket of commodity holdings, investors should likely limit exposure in the commodities markets to a reasonable percentage of their portfolio holdings. Investors who utilize the aid of a financial advisor should consult with them before incorporating new holdings into their longer term investment strategy.

Commodities as an asset class can be a bit more difficult to own outright. It is unadvisable that investors begin to trade in futures contracts around the commodity complex, unless this is something with which they have had significant experience. In most cases it is much more suitable to utilize a mutual fund or an ETF which diversifies across a broad range of futures contracts. Unfortunately, due to the structure of many commodity products in the ETF product space, they often report tax liability on a K-1 rather than a 1099. This is irrelevant for retirement accounts, and does not increase liability...but may delay income tax returns for non-retirement accounts, as K1’s tend to be issued later and often close to the tax deadline. In the event that an investor wishes to avoid the K1 filings, there are a number of open-ended traditional mutual funds that have broadly diversified commodity holdings. As in any mutual fund, expenses should be monitored as well portfolio holdings to ensure the fund achieves a truly diversified set of commodity holdings consistent with the benchmark. Below is a breakdown of the year over year comparison between US Large Cap Equities and the GSCI Commodity Index.

Multi Decade Historical Returns

Year
Large Cap Stocks
Commodities
1970
3.95%
15.11%
1971
14.31%
21.08%
1972
19.02%
42.44%
1973
-14.68%
75.01%
1974
-26.48%
39.54%
1975
37.22%
-17.22%
1976
23.92%
-11.89%
1977
-7.15%
10.37%
1978
6.56%
31.60%
1979
18.61%
33.80%
1980
32.49%
11.10%
1981
-4.90%
-23.01%
1982
21.55%
11.56%
1983
22.55%
16.56%
1984
6.25%
1.05%
1985
31.74%
10.02%
1986
18.67%
2.06%
1987
5.26%
23.77%
1988
16.59%
27.93%
1989
31.67%
38.29%
1990
-3.10%
29.07%
1991
30.46%
-6.14%
1992
7.65%
4.44%
1993
10.08%
-12.33%
1994
1.32%
5.31%
1995
37.57%
20.35%
1996
22.96%
33.91%
1997
33.38%
-14.06%
1998
28.58%
-35.75%
1999
21.04%
40.90%
2000
9.09%
49.77%
2001
-11.88%
-31.94%
2002
-22.10%
32.08%
2003
28.69%
20.72%
2004
10.87%
17.72%
2005
4.89%
25.55%
2006
15.79%
-15.10%
2007
5.50%
32.68%
2008
-36.99%
-46.49%
2009
26.45%
13.47%
2010
15.05%
9.04%
2011
2.12%
-1.18%
2012
15.98%
0.06%
2013
32.41%
1.21%

Comments

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    • profile image

      Kristy 

      3 years ago

      Pecrfet shot! Thanks for your post!

    • LandmarkWealth profile imageAUTHOR

      LandmarkWealth 

      3 years ago from Melville NY

      Mr. Kee is a real estate developer to the best of my knowledge. I am not sure how he pertains to the correlation of commodities with traditional asset classes in a strategic asset allocation.

    • profile image

      Julian 

      3 years ago

      my guess on the topic of discrepant 2628 3Q resutls:1. Page 14 of 1H08 Results, PRC GAAP Net Profit = 10.772B2. Page 2 of 2Q08 Results, Net Profit = 2.339B10.772B + 2.339B = 13.111B Net Profit according to HK GAAP of 1H08 = 15.838B in 1H08 Report.Does the above explain Tony's observation?By the way, Mr Market, what do you think about Lee Shau Kee's decision to offload 2628?

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