What you want (hooo), baby I got it
What you need (hooo), you know I got it
(Hooo) all I’m asking (hooo), is for a little respect.
…R-E-S-P-E-C-T, learn now what it means to me.
(…Sock it to me, sock it to me…)

-- Aretha Franklin, “Respect,” Atlantic Records

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Good-bye to the days where stocks and bonds (and maybe real estate) alone carried the snobby patina of smart investing.

But it had to happen. After years of being forced to stand in the shadows of more “traditional” investments, commodity futures are finally getting some respect and becoming more mainstream. It is remarkable that it took two professors, one from Yale and one from Wharton, to determine what futures industry insiders had known all along – that commodity futures were more than a little worthy of being part of any diversified portfolio.

The impact of the study may have been somewhat predictable, too. In commodity circles, there’s an air of vindication. It probably didn’t hurt that the stock market has been doing a sideways number for months after making a decent comeback in 2003. Or that China and India have been huge consumers of commodities, which will only increase in the future. Or that the Fed may not be as accommodative as it has been in the past several years, requiring some sort of hedge against inflation down the road.

Facts and Fantasies
But be that as it may, it’s not what sparked the study when Wharton professor Gary Gorton and Yale School of Management professor K. Geert Rouwenhorst last summer released their working paper, entitled “Facts and Fantasies about Commodity Futures,” through the Yale International Center for Finance. In it, they disproved some of the long-held views about commodity futures and put them squarely into a camp in which they had never been officially “invited” – as an asset class unto themselves.

Over the last 45 years (the span of the study), say Gorton and Rouwenhorst, commodity futures have yielded the same returns as stocks with lower risk and have outperformed bonds big time. That commodities offer better diversification as an asset class, including their behavior during specific parts of the business cycle and their reaction to unexpected inflation, makes them worth consideration by investors who, heretofore, may never have taken their blinders off to the possibilities. On top of that, the two professors say, they are a much better hedge against inflation than the other two.

Since Harry Markowitz (1990 Nobel prize winner along with William Sharpe and Merton Miller) pioneered what many consider the classic asset optimization framework some 50 years ago, little had changed. The belief that plan assets were invested for the long term, and in the long run equities outperformed bonds, led to the rule-of-thumb formula for pension plan sponsors’ asset allocations – two-thirds equity and one-third fixed income. But there has been a little loosening of the collar over the past couple of decades, and even the staunchest stock-and-bond guy has been willing to cede a few percentages here and a couple of percentages there within a portfolio for what they consider other “quasi”-asset classes.

What really matters for the pension fund manager as relates to assets is the return dynamics relative to the risk of the assets. That is why the Yale study is of such importance – because, if one accepts the premises under which the study was launched – then those who manage pensions, trustees of funds, and other fiduciaries will have to look at commodity futures – not as the red-headed stepchild – but in a more legitimate, risk-averse light.

Bad Rap
“Commodities have had an unjustified bad rap over the years, but this study changes all of that and reaffirms them as a true asset class,” says Jim Rogers, independent investor, and co-founder with financier George Soros of the Quantum Fund. “Just like the academic study done in the late ‘70s/early ‘80s that legitimized junk bonds and, for stocks, an important study in the late 1960s, this study will change the investment world. Commodity futures will be difficult to avoid now that people know they can offer a better return with less risk and a better hedge against inflation than stocks and bonds.”

The prospects have the commodity crowd excited. What this means is more capital from the pension funds, even if it’s a few years hence. Rogers says there will probably be a bit of a lag time before the real rush to commodities begins in earnest, just as with the studies on stocks and the junk bonds (which ultimately, despite their efficacy, were turned on their once-respectable heads by Michael Milken).

SIDEBAR
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Measuring the Results: The Surprises

Here’s how Drs. Rouwenhorst and Gorton came to their conclusions. They created an equally weighted performance index of commodity futures, based on data from the Commodities Research Bureau. They then compared the performance of their commodity index to the Ibbotson corporate bond index and the S&P 500 index from July 1959 through March 2004. All three data series were deflated by the CPI index in order to create an inflation-adjusted performance for the various asset classes.

The good news is that they have proven that commodity futures returns are indeed negatively correlated with equity and bond market returns, key for someone seeking to diversify and still gain positive returns when stocks are in a down cycle, or even dancing sideways. Also, the negative correlation between commodities and stocks and bonds actually increases with the holding period. That has interesting implications for those with retirement plans who are eager to juice up their stale returns.

Another myth that many individual investors may have is that commodity futures ultimately offer more potential for losses. Now, this may be true for individuals who are speculating on a short-term basis in the futures markets. But, Gorton and Rouwenhorst actually found that “equities contain more downside risk than commodity futures,” based on their comparison of an equally weighted performance index of commodity futures that they constructed and tested over the 45-year time period. In their paper, they highlight some additional statistics that may be surprising to some:

• "During the five percent of the months of worst performance of equity markets, when stocks fell on average by 9.18 percent, commodity futures experienced a positive return of 1.43 percent, which is slightly more than the full sample average return of 0.88 percent per month."

• "During the one percent of months of lowest performance of equity markets, when equities fell on average by 13.87 percent, commodity futures returned an average of 2.32 percent."
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What Are the Big Boys Doing?
Ellen Sullivan is a director of Sax Holbein, Ltd., in Frankfurt, Germany, a company that markets specialty products to institutional investors. The company is currently selling a structured note based on the Dow Jones-AIG Commodity Index. “The time couldn’t be more right for this study to be released,” says Sullivan. “After a 20-year bear market and Paul Volcker breaking the back of inflation, we think we’ll see some changes with the institutions’ attitudes.”

Pension funds indeed are upping the allocation of alternatives to stocks and bonds with little buyer’s remorse. These institutional players have been picking up on these trends, and money has been flowing into investments that are pegged to commodity indexes, such as the Goldman Sachs Commodity Index and the Dow Jones-AIG Commodity Index, both of which are heavily weighted in the energy products.

Is it time to shift to hard assets? Those who were pioneers in this arena have done well. According to a Sept. 9, 2004, Wall Street Journal article, “the rush to commodities…already is well under way.” The article notes that the Ontario Teacher’s Pension Plan devoted more than six percent of its 79 billion Canadian dollars (US$61 billion) in assets to commodity-related investments. Back in 2002, that percentage was just 2.2 percent of assets, which paid off to the tune of a 30.4-percent return.

As impressive is the fact that, again according to the Journal, “Harvard University has been investing in commodities for more than a decade, and its internal benchmark calls for allocating 13 percent of the university’s $19.3 billion endowment to oil, gas and other commodities. That’s just two percentage points less than the weighting assigned to U.S. stocks and two points more than the allocation to U.S. bonds.”

The other thing to consider, says Rogers, is that a lot of investors are going to say, for example, “Fine then; I’ll just invest in copper shares rather than copper itself.’ What they have to remember is that many times, commodities have gone up, but stocks haven’t. And with stocks, you have to take into account what’s happening to the stock market, management, unions, environmentalists, the government, balance sheets, pension plans, off-balance sheets – in other words, a dozen different things. This study makes it very clear that investing in the stock is not the best way.”

Digging Deeper
As with every study, there are those who inevitably take exception to some of the elements within. Christian Busken, research analyst for Fund Evaluation Group (FEG) in Cincinnati, a company that advises endowments and foundations on their portfolios, is one who has a few concerns. “If you look at the spot prices of 17 different commodities from 1951 to 2001, there are only three that outpace the Commodity Price Index – natural gas, crude oil and gold. Most of them, in fact, don’t keep pace with inflation as measured by CPI over the long term.”

This doesn’t mean, however, that FEG is anti-commodity. He says there are certain commodities that are indeed attractive over the long term, timber for one. “But,” says Busken, “you have to look at commodities individually or on a sector basis rather than as an asset class, because what affects the price movement of grains will have nothing to do with the price of oil. Perhaps energy looks attractive, but does that mean you want to make an allocation to a long-only commodity index, or does it make more sense to focus on gaining exposure to energy alone?”

“It would seem,” he suggests, “to make more sense to approach commodities by way of managed futures where a CTA will look at each commodity on an individual basis, and go both long and short. It’s just a matter of finding funds whose fees aren’t too high to make it worth the while.”

Howard Simons, president of Simons Research, Chicago, which provides economic and financial analyses and commodity trading advisories for firms, traders and exchanges, says the study has merit, but it’s important to look deeper to understand the entire picture. “Nearly all commodities without a direct economic relationship to each other, such as heating oil to crude oil, have a very poor correlation of returns. You could win a few barroom bets that crude oil and gold have less than a 16-percent correlation of returns, but that’s what the numbers say.”

Remember, he says, “that the long-term trend is for prices to move lower in inflation-adjusted terms after these short-lived price spikes. Only a few commodities, notably gold, follow inflation higher. Most move higher only after either a supply disruption, a demand shock, or a period of strong economic growth following years of low investment in productive assets. The last situation describes today’s environment.”

“The most valuable and enduring contribution of the Gorton/Rouwenhorst study could be their demonstration, once again, that commodities are not intrinsically more volatile than conventional assets,” adds Simons.  Of course, demonstrating something and having people really believe it are two different things.  Many of the same portfolio managers who chased technology stocks during the bubble of the 1990s either regard commodities as too dangerous and illiquid, or simply are prohibited by charter from participating in these markets.

“But,” concludes Simons, “the world is changed in small ways one step at a time.  And this study certainly will get some people to look at the data and start asking the right questions.”