Download - Commodities in a Traditional Investment Portfolio Timothy J. Rudderow Friday, 4 March 2005
Commodities in a Traditional Investment Portfolio
Timothy J. Rudderow
Friday, 4 March 2005
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Commodities are HOT
Search for non-correlated return
Adding commodities to investment portfolios has gained traction
Accessible commodity index products have simplified the analysis
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Question #1
“In each of the other asset classes in my portfolio, I understand the economic risk premium I earn when I make the investment. It helps me form ideas about expected return and risk.”
What is the economic risk premium in a commodities investment?
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“If I add a commodities investment to my portfolio, what is the impact?”
• Can I make a difference?
• Leverage?
• Does the volatility help or hurt the portfolio?
• Will I lose my job?
Question #2
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Risk Premium: Motivation
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Wheat CPI
Past performance is not necessarily indicative of future results.
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Risk Premium
Risk Premium arguments look to the futures markets
Futures markets exist to allow commercial interests to reduce price and rate risk
Logical that the eventual holder of that risk earns a risk premium
Challenge is in the measurement – an Index• Must be passive and price based• Must be able to replicate in the market
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Hedging Today
CHINA
Global Bonds $$
$$ Products
Raw Materials $$
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Risk Premium: Method #1
Keynes: Normal Backwardation• Futures trade at a discount to spot to
compensate the risk bearer• Son of Keynes: Goldman Sachs Commodity
Index• Younger Sibling: DJAIG Commodity Index
Index construction• Long a basket of commodity futures• Market weights based on production
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Method #1
Components of return• Change in the price of the spot commodity• Normal backwardation premium (or
discount) in the futures price• Risk Free interest rate
Most bang in rising commodity environments
Best in non-storable markets
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Method #2
Background• My bias: Full disclosure• “What is the Benchmark?”
Market Realities• Hedgers on both sides of the markets• Specs are long and short, too
Volatility represents risk to business interests
• Back to the wheat chart
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MLM Index™ Construction
• Recently “modernized”
• 22 futures markets
• Volatility Weighted Baskets
• Unleveraged
• Rebalanced monthly
• Positions can be long or short
• Transparent
Commodities
Global BondsCurrencies
Natural GasSoybeansSugarUnleaded GasWheat
Australian DollarBritish PoundCanadian DollarEuro CurrencyJapanese YenSwiss Franc
Canadian Govt BondEuro BundJapanese Govt BondLong GiltTen Year Notes
CornCrude OilCopperGoldHeating OilLive Cattle
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Method #2
Components of return• Gains from long and short positions• Risk free rate of interest
Performance• Does well in sharply rising or falling markets• Does poorly when markets are in equilibrium
Broadens the risk premium argument to the full range of markets – all futures
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Side Thought: Alpha and Beta
Sources: CTA is the CSIDM/MAR CTA Index, Jan-92 thru Dec-04 (www.marhedge.com) CSFB is the CSFB Managed Futures Index , Jan-94 thru Dec-04 (www.hedgeindex.com) MLM is the simulated modernized MLM Index™
S&P 500 MLM Index™
Alpha Beta Alpha Beta
MAR CTA Index 0.83% -0.05 -0.08% 1.34
t-stat 3.85 -1.07 -0.40 8.30
CSFB HF Index 0.77% -0.15 -0.35% 1.48
t-stat 2.50 -2.22 -1.09 5.92
Past performance is not necessarily indicative of future results.
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Return Summary
Jan-1992 to Dec-2004 GSCI
DJ-AIG Commod.
IndexMLM
Index™
Pre-Modernized MLM Index™
S&P 500
LB Aggregate
Bond
Zurich CTA
Index
1 Year 17.3% 9.1% 5.7% 3.5% 10.9% 4.2% 4.4%
3 Years 87.0% 70.3% 21.3% 5.8% 11.1% 19.6% 32.4%
5 Years 90.6% 80.7% 38.2% 27.5% -11.0% 44.8% 46.5%
Inception To Date 130.3% 169.0% 168.8% 139.9% 275.0% 140.5% 215.8%
Annual Return 6.6% 7.9% 7.9% 7.0% 10.7% 7.0% 9.2%
Standard Deviation 19.9% 13.0% 4.1% 6.6% 15.9% 4.1% 9.9%
Sharpe Ratio 0.23 0.38 1.03 0.51 0.51 0.79 0.59
Correlation w/S&P 500 0.01 0.09 -0.09 -0.21 1.00 0.05 -0.09
Past performance is not necessarily indicative of future results.
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Relationship with other Assets
MLM
Index™
Pre-Modernized MLM Index™
CTA Index
S&P 500 GSCI
DJ-AIG Commod. Index
LB Aggregate Bond CPI
MLM Index™ 1.00
Pre-Modernized MLM Index™ 0.65 1.00
CTA Index 0.56 0.30 1.00
S&P 500 -0.09 -0.21 -0.09 1.00
GSCI 0.08 0.08 0.15 0.011.00
DJ-AIG 0.06 0.09 0.21 0.090.89 1.00
LB Agg. Bond 0.41 0.14 0.35 0.050.07 0.04 1.00
CPI -0.11 -0.10 -0.08 -0.070.11 0.09 0.01 1.00
Past performance is not necessarily indicative of future results.
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Why a Risk Premium?
Inelasticity of the underlying markets• Makes commercial markets different than
equity markets• It’s the reason businesses hedge
Competition for capital• Without a risk premium, futures markets
become a casino – no reason to play• Premium should be competitive with other
capital markets.
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Question #2: Portfolio Impact
The Holy Grail• Positive return
• Mark to Market
• An measurable economic risk premium
• No correlation with traditional assets
COMMODITIES
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Motivation: Volatility is Your Friend
Past performance is not necessarily indicative of future results.
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Asset Class ReturnsVarious Indices Comparison (Jan 80 - Dec 04)
100
1,000
10,000
100,000
Dec
-79
Dec
-80
Dec
-81
Dec
-82
Dec
-83
Dec
-84
Dec
-85
Dec
-86
Dec
-87
Dec
-88
Dec
-89
Dec
-90
Dec
-91
Dec
-92
Dec
-93
Dec
-94
Dec
-95
Dec
-96
Dec
-97
Dec
-98
Dec
-99
Dec
-00
Dec
-01
Dec
-02
Dec
-03
Dec
-04
MLM Index
MLM Index 3X
GSCI
LT Gvt
Russell 1000
Russell 2000
Hi-Yld Corp
LT Corp
10.65%10.67%LT Corp
9.25%11.27%Hi-Yld Corp
22.30%12.45%Russell 2000
17.67%13.34%Russell 1000
12.47%10.61%LT Gvt
18.91%8.50%GSCI
26.27%19.06%MLM Index 3X
8.11%10.78%MLM Index
Std DevAnnual Rtn
10.65%10.67%LT Corp
9.25%11.27%Hi-Yld Corp
22.30%12.45%Russell 2000
17.67%13.34%Russell 1000
12.47%10.61%LT Gvt
18.91%8.50%GSCI
26.27%19.06%MLM Index 3X
8.11%10.78%MLM Index
Std DevAnnual Rtn
Past performance is not necessarily indicative of future results.
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Asset Class Returns
Past performance is not necessarily indicative of future results.
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Baseline PortfolioEffects on Efficient Frontier
by Adding Futures to a Mix of Stocks and Bonds
8%
10%
12%
14%
16%
18%
20%
4% 6% 8% 10% 12% 14% 16% 18% 20% 22%
Standard Deviation
Compound Annual ReturnLarge & Small Caps, LT Govt, LT Corp & Junk
Period Jan 1980 - Dec 2004
50% Large Cap
50% Small Cap
0% LT Govt
0% Junk Bonds
0% LT Corp
0% Large Cap
0% Small Cap
33.3% LT Govt
33.3% Junk Bonds
33.3% LT Corp
20% Large Cap
20% Small Cap
20% LT Govt
20% Junk Bonds
20% LT Corp
0% Large Cap
0% Small Cap
0% LT Govt
0% Junk Bonds
0% LT Corp
100% GSCI
0% Large Cap
0% Small Cap
0% LT Govt
0% Junk Bonds
0% LT Corp
100% MLM 1X
8% Large Cap
8% Small Cap
8% LT Govt
8% Junk Bonds
8% LT Corp
60% MLM 1X
Past performance is not necessarily indicative of future results.
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Adding GSCIEffects on Efficient Frontier
by Adding Futures to a Mix of Stocks and Bonds
8%
10%
12%
14%
16%
18%
20%
4% 6% 8% 10% 12% 14% 16% 18% 20% 22%
Standard Deviation
Compound Annual ReturnLarge & Small Caps, LT Govt, LT Corp & Junk
With GSCI
Period Jan 1980 - Dec 2004
50% Large Cap
50% Small Cap
0% LT Govt
0% Junk Bonds
0% LT Corp
0% Large Cap
0% Small Cap
33.3% LT Govt
33.3% Junk Bonds
33.3% LT Corp
20% Large Cap
20% Small Cap
20% LT Govt
20% Junk Bonds
20% LT Corp
0% Large Cap
0% Small Cap
0% LT Govt
0% Junk Bonds
0% LT Corp
100% GSCI
0% Large Cap
0% Small Cap
0% LT Govt
0% Junk Bonds
0% LT Corp
100% MLM 1X
8% Large Cap
8% Small Cap
8% LT Govt
8% Junk Bonds
8% LT Corp
60% MLM 1X
Past performance is not necessarily indicative of future results.
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Adding MLM Index™Effects on Efficient Frontier
by Adding Futures to a Mix of Stocks and Bonds
8%
10%
12%
14%
16%
18%
20%
4% 6% 8% 10% 12% 14% 16% 18% 20% 22%
Standard Deviation
Compound Annual ReturnLarge & Small Caps, LT Govt, LT Corp & Junk
With GSCI
With MLM
Period Jan 1980 - Dec 2004
50% Large Cap
50% Small Cap
0% LT Govt
0% Junk Bonds
0% LT Corp
0% Large Cap
0% Small Cap
33.3% LT Govt
33.3% Junk Bonds
33.3% LT Corp
20% Large Cap
20% Small Cap
20% LT Govt
20% Junk Bonds
20% LT Corp
0% Large Cap
0% Small Cap
0% LT Govt
0% Junk Bonds
0% LT Corp
100% GSCI
0% Large Cap
0% Small Cap
0% LT Govt
0% Junk Bonds
0% LT Corp
100% MLM 1X
8% Large Cap
8% Small Cap
8% LT Govt
8% Junk Bonds
8% LT Corp
60% MLM 1X
Past performance is not necessarily indicative of future results.
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Adding LeverageEffects on Efficient Frontier
by Adding Futures to a Mix of Stocks and Bonds
8%
10%
12%
14%
16%
18%
20%
4% 6% 8% 10% 12% 14% 16% 18% 20% 22%
Standard Deviation
Compound Annual Return
Large & Small Caps, LT Govt, LT Corp & Junk
With GSCI
With MLM
With MLM 3X
Period Jan 1980 - Dec 2004
50% Large Cap
50% Small Cap
0% LT Govt
0% Junk Bonds
0% LT Corp
0% Large Cap
0% Small Cap
33.3% LT Govt
33.3% Junk Bonds
33.3% LT Corp
20% Large Cap
20% Small Cap
20% LT Govt
20% Junk Bonds
20% LT Corp
0% Large Cap
0% Small Cap
0% LT Govt
0% Junk Bonds
0% LT Corp
100% MLM 3X
0% Large Cap
0% Small Cap
0% LT Govt
0% Junk Bonds
0% LT Corp
100% GSCI
0% Large Cap
0% Small Cap
0% LT Govt
0% Junk Bonds
0% LT Corp
100% MLM 1X
16% Large Cap
16% Small Cap
16% LT Govt
16% Junk Bonds
16% LT Corp
20% MLM 3X
8% Large Cap
8% Small Cap
8% LT Govt
8% Junk Bonds
8% LT Corp
60% MLM 1X
Past performance is not necessarily indicative of future results.