Understanding alternative investments: The role of commodities in a portfolio

Understanding alternative investments: The role of commodities in a portfolio

Kimberly A. Stockton, Vanguard Investment Counseling & Research, (08/02/2007)

Introduction

In recent years, a passive investment in commodities provided high, equity-like average returns, negative return correlations with traditional asset classes, and some protection against inflation. Augmenting a traditional portfolio with an allocation to commodity investments would have improved risk-adjusted portfolio returns. Consequently, interest in commodity investments has increased tremendously. This paper will describe the most popular means of passively investing in commodities—commodity futures indexes—and will discuss their role in a well-diversified portfolio. Although historical returns serve as a useful guide, long-term asset allocation decisions must be based on forward-looking expectations about commodity returns. Detailed analysis of commodity futures index returns will identify key drivers needed to form those expectations. Commodity futures index returns may be broken down into collateral return (U.S. Treasury bills), spot return (the return from changes in commodity prices) and roll return (the return associated with rolling a futures contract forward). Over long periods, the spot return is on average not much higher than inflation, so the roll return is an important contributor to the equity-like returns achieved by some commodity investments. Unfortunately, there is evidence that the roll return is declining or even disappearing in markets where it traditionally has been strongest (such as energy futures markets). So, although a small allocation to commodities may provide some diversification benefits, we caution against making an allocation to commodity investments based on extrapolations of historical returns.

Note: This post has been added to Asset Class Reader: Commodities