In 1986, an article was published in TheFinancial Analysts Journal that changed the investment world. Three researchers – Gary P. Brinson, L. Randolph Hood, and Gilbert L. Beebower (collectively “BHB”) – compared the performance of actively managed pension funds to the performance of index funds. They found that asset allocation choices, not individual security selection, accounted for more than 96% of the variation between active and indexed portfolios.
The research served as rocket fuel for a two-decade boom in asset allocation. Published at an opportune time in the investment industry’s growth, BHB has been used by countless financial advisors to convince clients that asset allocation works over time.
Almost exactly 20 years later, another article was published by two researchers in the same publication. This article lays the groundwork for the next leap forward in asset allocation. It also appeared at a remarkable time, when industry innovations and economic/market cycles were creating new opportunities for managing risk, increasing returns, and expanding efficient frontiers.
In this article, you will learn about the work of these two researchers and why their findings may be as important in the future as BHB has been in the past. You also will see why commodities futures, and exchange-traded funds (ETFs) that combine them, may hold the key to your clients’ asset allocation success.
Enter Erb & Harvey
The ground-breaking 2006 research study was published in the Financial Analysts Journal by Claude B. Erb, CFA and Campbell R. Harvey and titled: The Strategic and Tactical Value of Commodity Futures. You can access it in full online here:
To set the stage, BHB was published near the onset of a golden age of equity investing. It helped a confident investment industry, working in a growing U.S. economy and booming stock market, capture assets under management in style-based U.S. equities.
The Erb and Harvey research, on the other hand, is tailor-made for a new era of global asset allocation, including alternative asset classes. During an era of economic disarray and stock market turmoil, it offers advisors a sensible way to maintain asset allocation disciplines while increasing diversification and reducing volatility.
Like BHB, Erb and Harvey began by comparing the actual performance of investments over time to index funds. Specifically, they compared the mean return produced by individual commodities futures contracts, most of which are highly volatile, to indexes composed of these same contracts and rebalanced periodically.
On an individual basis, they found that commodities futures contracts have been relatively unrewarding investment. The average historic median return of 36 individual contracts from 1959-2004 was just 0.03% above Treasury bill returns.
The researchers then showed that an equally-weighted, rebalanced index of these same contracts has produced annual historical portfolio returns 2% to 4% higher than the historic median return of the individual contracts. They called this extra return “diversification benefit” and attributed it to the fact that individual commodities contracts are highly volatile and also tend to have somewhat low correlations with other contracts.
They concluded that the diversification benefit is not dependent upon the asset classes chosen but rather statistical variance reduction. It can be reliably achieved in any rebalanced portfolio that combines (on an equal weight basis) volatile asset classes with low correlations to each other. Because the diversification benefit acts like magic in boosting the efficient frontier and lifting returns, they called this phenomenon “turning water into wine.”
They explained their methodology with a simple example involving just two asset classes, the GSCI heating oil index and the S&P 500 Index, using data from the period 1993-2003:
“Heating oil had a geometric annual excess return of 8.21%, and the S&P 500 had a geometric annual excess return of 6.76%. The equally weighted average of these two returns is 7.49%. But the geometric excess return of an equally weighted, annually rebalanced portfolio is 10.95%. The so-called diversification return is simply the difference between 10.95% and 7.49% or 3.46%. In this example of ‘turning water into wine,’ the return of the rebalanced portfolio is much higher than the return of either of the two portfolio constituents.”
This example highlights the potential to capture diversification benefit in portfolios mixed between stocks and commodities futures ? because both asset classes can be somewhat volatile and correlations between them tend to be fairly low (near zero).
Spokes in the Wheel
The Erb & Harvey research serves as a hub concept around which other developments in commodities futures revolve. Here are several of the most important “spokes in the wheel” for asset allocation purposes:
- Leading indexes of mixed commodities futures contracts now have long-term track records that compare favorably to other asset classes. For the 10-year period ending 10/31/08, the S&P GSCI Total Return Index produced an average annualized return of 12.23%. The Dow-Jones AIG Commodity Index Total Return Index returned 9.93%. Over the same period, the S&P 500 Total Return Index returned just 3.06%.
- Low historic correlations have been documented between leading commodities indexes and traditional asset classes. For example, the Dow-Jones AIG Commodity Index Total Return Index has a correlation of -0.05 with the S&P 500 and -0.03 with the Lehman Brothers U.S. Aggregate Index (bonds).
Other research has helped to analyze the diverse set of return drivers available in commodities futures. For example, Hilary Till decomposed long-term returns in futures indexes and found that spot commodity prices have not had much impact on long-term performance. A greater influence has been the contributions of five specific futures contracts in which annualized historic returns have been far in excess of spot price appreciation, as summarized in the table below.
Annualized Returns from 4/83 to 4/04 Futures Contract Spot Price Crude oil 15.8% 1.1% Heating oil 11.1% 1.1% Gasoline (since 1/85) 18.6% 3.3% Copper 12.0% 2.3% Live cattle 11.0% 0.7%
Source: Structural Sources of Return and Risk in Commodity Futures Investments, Hilary Till, April 2006.
What helped these five contracts significantly outperform the corresponding spot commodities? The answer is their tendency toward “backwardated” term structures. In simple language, this means that near-expiration futures contracts cost more than longer-term. Each time an index rolls an expiring contract into a new contract, it does so at a lower price, picking up steady increments of yield. Over time, the rolled-up profits in just five contracts have made several commodity indexes top performers.
Attractive ETFs and exchange-traded notes (ETNs) composed of mixed commodities contracts have emerged just in the past 2+ years. These contracts enable financial advisers to add commodities weightings economically and conveniently to asset allocation programs. They can participate in Erb & Harvey’s diversification benefit internally (among component contracts) and externally by virtue of low correlations with stocks. The table below identifies several of these ETFs and ETNs.
Mixed Commodity ETFs and ETNs ETF or ETN Symbol Inception Component Contracts DB Commodity Index Fund DBC 2/3/06 Aluminum, corn, gold, heating oil, light crude, wheat iPath S&P GSCI TR Index* GSP 6/6/06 24 commodity contracts, 78% energy 12% agriculture, 6% industrial metals, 3% livestock and 2% precious metals iPath Dow Jones?AIG Com. Ind. Tr. * DJP 6/6/06 19 commodity contracts, 40% in energy, 28% agriculture, 17% industrial metals, 9% precious metals, 7% livestock iShares S&P GSCI Com. Ind. Tr. GSG 7/10/06 Tracks the same index and has similar composition to GSP above DB Base Metals Fund DBB 1/5/07 Aluminum, copper, zinc DB Agriculture Fund DBA 1/5/07 Corn, soybeans, sugar, wheat DB Energy Fund DBE 1/5/07 Brent and light crude oil, heating oil, natural gas, gasoline
* Exchange-traded note (ETN)
Innovative concepts in the ETF world may help to increase the long-term returns of mixed commodity indexes. For example, Deutsche Bank (DB) and Powershares have created a series of Liquid Commodities Indexes that they have trademarked “Optimum Yield (OY)” These indexes introduced a rules-based method for replacing expiring contracts so as to maximize roll yield advantage. For each expiring contract in the index, the OY formula performs an evaluation of similar contracts expiring in the following 13 months and then chooses the contract with the “highest implied roll yield.”
In back-testing the concept over the period 1988-2006, DB found that the OY roll formula added 52 basis points of annual return, compared to the same index with a traditional rolling method.
Practical Implementation Ideas
Many financial advisors are biased in favor of equities and against commodities. They believe commodities are volatile, risky and relatively unrewarding because they think futures returns mirror spot prices. While this may be true of some individual contracts, it is definitely not true of diversified commodities indexes.
Leading mixed commodities indexes now have long-term absolute returns, standard deviations (volatility), and risk-adjusted returns comparable to equities. Over the past decade, their absolute and risk-adjusted returns are superior. Mixed commodities indexes also have diverse return drivers including:
- Appreciation in spot commodities prices
- Ability to capture roll yield systematically in some contracts
- The interest earned on cash collateral deposited to buy futures contracts
- The Erb & Harvey diversification benefit of 2% to 4% per year
More importantly for overall asset allocation purposes, combinations of equities and mixed commodities futures indexes, equally weighted and rebalanced systematically, should outperform the averaged returns of the two asset classes through a kind of “super diversification benefit” – because both asset classes can be volatile and correlations between them are low. Adding bonds to the mix should not dilute this benefit greatly, even though bonds are not a volatile class.
Based on historical data, there is a very strong probability that a 50-50 mix of equities and mixed commodities futures indexes will outperform an equities-only portfolio on a risk-adjusted basis over time. Accepting this simple fact gives financial advisors a strategic way to reduce the equity-heavy concentrations in clients’ portfolios, reduce short-term volatility, increase global diversification, and better manage risk.
Of course, some clients may be concerned about the sharp decline in commodities prices that began in July of this year and continued through the bear market rout of September-October. The hypothetical 50-50 equities-futures portfolio would have performed very poorly during this period, and clients may wonder whether it indicates an increased correlation between stocks and futures. While the jury is still out, this period may be a historical rarity caused by an unprecedented global de-leveraging event that negatively affected all asset classes except cash.
Very few financial advisors are yet mentally prepared to commit large portions of allocation models to commodities futures. But it’s a goal to work toward, and here are specific ideas:
- For the broadest exposure to the greatest variety of futures contracts, allocate with DJP, GSP, or GSG.
- DBC is an attractive “one-solution” tool for implementing commodities futures into asset allocations, for two reasons. Compared to DJP, GSP or GSG, it weights components closer to the equal-weight methodology advocated by Erb & Harvey for maximizing diversification benefit. Also, it has the potential to increase roll yield if Deutsche Bank’s OY formula proves successful over time.
- The Deutsche Bank-Powershares ETFs focused on specific futures complexes (DBB, DBA, DBE) can be useful in tactically adjusting commodities exposure. They also can be used to tailor allocations to specific client preferences for base metals, food and energy, respectively.
- As an energy-only mixed ETF, DBE can be especially valuable in helping clients hedge against higher oil and gasoline prices, and higher inflation rates in general. Add DBA to the mix if clients are worried about increases in food prices.
The Big Picture
For both stocks and commodities futures, cycles of opportunity historically have lasted decades. For example, U.S. stocks enjoyed a bull market from 1950 through 1972 and then another strong run from 1980 through 2000. However, it is possible that the U.S. stock market is now buried in a bear market that began in 2000 and may last a decade or more.
Commodities futures had one strong run from 1971 through 1982 and another that began in 2002. While it is possible that this commodity up-cycle ended in mid 2008, it is not likely for three reasons: 1) massive liquidity has recently been created by central banks and governments around the world and it may wash back into higher inflation in the years ahead; 2) the U.S. dollar remains vulnerable to downward pressure, especially against the “universal currency” of gold; and 3) economies of emerging markets (especially in Asia) may rebound from the current economic downturn faster than the U.S., refueling demand for scarce commodities.
All of these points reinforce the case that we may still be in a golden age of commodities, well before the next golden age of equities begins. Help your clients navigate these difficult times with low-correlation global asset allocation strategies designed to take advantage of innovation and opportunity.