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.

21

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.