|
|
|
Wealth Management 2005 from
|
|
Commodity myths
" By David Baker
Executive director, UBS Wealth Management
‘There is thy gold; worse poison to men’s souls, Doing more murther in this loathsome world, Than these poor compounds that thou mayst not sell.’ – William Shakespeare.
Is he right? No asset class is burdened by as much myth and fantasy as commodities, while at the same time there is barely an asset class more overlooked than commodities. Great riches – entire empires even – have arisen thanks to them. Great riches – and also entire empires – have also been lost as a result of them.
Thanks to recent exceptionally high returns, investor focus has once again returned to commodities. Not bad, considering that five years ago the trend was for investments in anything light, virtual and fast. People thought that commodities were heavy and clumsy beings from a prehistoric age. Now the tables have turned and the call is for investments that are solid, down-to-earth and concrete. But is this new craze also subject to a tad too much euphoria?
Figure 1.1. (right, above) shows the relationship between equity and commodity prices. Over the period 1875–2004, US equities outperformed commodities by some 2.3% per annum. However, commodities outperformed US equities by 8.4% p. a. between 1906 and 1920, by 5.9% p.a. between 1929 and 1949 and by 7.4% p.a. between 1969 and 1983. In the 20th century, there were three major commodity bull markets, each lasting an average of 15 years.
There are several explanations as to why prolonged periods of commodity outperformance are followed by prolonged periods of commodity underperformance, ie 15-year commodity cycles. The most simple and straightforward explanation for this could be the affects of supply and demand on raw material costs and the corresponding impact on stock market values.
Commodities in the 1970s attracted a great deal of attention from institutional and private investors, but they disappeared from portfolios in the 1980s and 1990s due to their weak performance compared with equities. With the recent surge in commodity returns and weak stock markets, however, investors have begun to rediscover Commodities as an asset class that can offer attractive returns together with portfolio stabilisation qualities. This interest in commodities might just be a fad based on a short-lived rally. We don’t think so. A closer inspection of the recent performance of the DowJones-AIG-Total Return indices shows that the current commodity boom is mainly due to the out performance of energy and metal commodities while agricultural commodities have generated much lower total returns. Fig 2.1 (right, below) shows the historical risk and return of the six major commodity subclasses for the past five and the past ten years.
Looking at the performance of several asset classes in the past twenty years from a USD perspective, we see that an investment in the leading commodity indices has produced returns that are similar to the returns of equities with a slightly higher volatility. Since the demand for commodities is mainly driven by global industrial production and in recent times also by increasing demand from China, the annual returns can vary considerably.
The correlation between two asset classes measures how much in line the two asset classes will behave. A correlation of +1 means that the two asset classes will be perfectly in line. If one asset class produces positive returns, the other asset class will do so as well. If one asset class has negative returns, the other will, too. A correlation of –1 would mean that one asset class would generate positive returns whenever the other asset class suffers losses. In general, the lower the correlation, the better the diversification effect of these two asset classes because, on average, one asset class will tend to outperform whenever the other one underperforms. A combination of these two asset classes will generate returns that are more stable over time and hence reduce the risk of the portfolio.
The average correlation between commodities and other major asset classes is generally very low – even to asset classes like real estate and hedge funds. From a portfolio perspective, these very low correlation values of commodities with other asset classes make them a very attractive means of diversification.
Considerations about the diversification characteristics of commodities leads us to conclude that Commodities should be included in a portfolio because of their ability to stabilise the returns of a mixed portfolio, and hence reduce total portfolio risk.
However, low correlation to other asset classes is just one reason why commodities should be included in a mixed portfolio. Attractive returns, as generated with commodities in the past, might well be another. Based on a forecasting model, which includes business cycle components and interest-rate components, we expect a long-run return of around 8% p.a. (with a standard deviation of around 12% p.a.), which is slightly less than the average of the past ten years (8.5% p.a.) and also significantly less than the returns on commodities over the past five years (above 12% p.a.).
We see that commodities are an attractive asset class that can enhance portfolio efficiency and offer at least some degree of inflation protection. Indeed, the diversification potential of this asset class is larger than for some other alternative asset classes like hedge funds or real estate. Commodities have long been neglected by many investors due to a lack of adequate investment vehicles. However, this situation is changing and we think it is time that commodities should be considered as an addition to broadly diversified portfolios.
|
|
|
|
