Hot commodities attracting attention and skepticism

Commodity futures may be a great asset class, but now might be a lousy time to start investing in the contracts.

A new study by Ibbotson Associates, Chicago, found that institutions could invest as much as 31% of total assets in commodity futures as part of their strategic asset mix without increasing their risk level, based on historical returns.

The numbers are so high that even Ibbotson officials are scratching their heads.

"Even internally, we're still coming to grips" with the results, said Tom Idzorek, research director at Ibbotson, a unit of Morningstar Inc., Chicago. "These are some substantial numbers, and far larger than what some people are used to. What's clear is that an allocation to commodities makes sense."

From 1970 through 2004, commodity futures would have boosted the average portfolio return by about 133 basis points, as well as provided diversification against stocks and bonds, the study found. The study was commissioned by Pacific Investment Management Co., Newport Beach, Calif., which offers commodity-related investment strategies.

But other experts argue this is about the worst possible time to make the plunge into the volatile asset class, given its dramatic run-up in recent years. For the three-year period ended March 31, Goldman Sachs Commodities index returned 18.8% on a compound annualized basis. Some experts believe investing in commodity futures now would be buying at the top of the market.

"Since the rally we are experiencing is already bigger and longer lasting than the one that kicked off the '70s, it takes a determined optimist to say that now is (the) time to be putting money in commodities," Bill Miller, chairman and chief investment officer of Legg Mason Capital Management, Baltimore, wrote in a recent client letter.

Added Campbell Harvey, a finance professor at Duke University's Fuqua School of Business, Durham, N.C., in an e-mail to Pensions & Investments: "In my opinion, it is naive to think that the past performance of commodity futures will be replicated in the future. In addition, with the heavy institutional buying interest, the expected returns are being driven down further."

Institutional interest has been huge. Officials at Barclays Global Investors, San Francisco, estimate $35 billion in institutional money poured into commodity futures last year, bringing the total to $80 billion at year-end 2005. Most of that money is passively invested.

Of more than $85 billion tracking various commodities indexes as of March 31, about 65% is benchmarked to the GSCI, which is nearly three-quarters invested in energy-related commodities.

With major pension funds such as the $210 billion California Public Employees' Retirement System, Sacramento, and the £35.8 billion ($66.8 billion) BT Pension Scheme, London, eyeing the asset class, a flood of additional money might be following.

Commodity futures' superior historic performance only recently has been recognized. In a widely cited paper, Gary Gorton, a professor at the University of Pennsylvania's Wharton School, Philadelphia, and K. Geert Rouwenhorst, a professor at Yale University's School of Management, New Haven, Conn., found that commodity futures generated equivalent returns to U.S. stocks but with lower volatility, based on an equal-weighted benchmark built from July 1, 1959, to Dec. 31, 2004.

The Ibbotson study took a different approach. Mr. Idzorek created an equal-weighted benchmark composed of the three leading commercial indexes — the GSCI, the Dow Jones-AIG Commodity index and the Reuters/Jefferies CRB index — plus Messrs. Gorton and Rouwenhorst's index. Unlike traditional stock or bond indexes, the commodity indexes have widely different components and characteristics.

The result: $1 invested in the Ibbotson combined commodity index from January 1970 through October 2005 would have generated $71.62. In comparison, $1 invested in U.S. stocks and bonds would have produced $42.21 and $18.96, respectively.

The compound annualized return for Ibbotson's benchmark was 12.4% — a premium of 6.1 percentage points above Treasury bills.

Using that 6.1-point premium, a traditional optimizer would allocate 22% of assets to commodities, drawn largely from fixed income, for a portfolio with a standard level of risk, the study found. More sophisticated asset allocation models suggested the maximum commodities allocation could run as high as 31%, the Ibbotson study said.

But assuming that risk premium continues takes a big leap of faith. Instead, Mr. Idzorek slashed the return premium for commodity futures to 200 basis points. Even with that haircut, Ibbotson models suggested strategic allocations of 11.1% to 12.6% for commodity futures.

"That suggests that the large allocations to commodities are not necessarily driven by high expected return forecasts," Mr. Idzorek said in an interview. "What's driving allocations to commodities is the high diversification benefits."

Wilshire Associates Inc., Santa Monica, Calif., arrived at a similar conclusion. In a March 2005 study, Wilshire found that a portfolio with a 20% allocation to commodity futures added 13 basis points in return while keeping risk at the same level. What's more, allocating an additional 20% to real estate investment trusts boosted returns another 28 basis points.

In reality, institutional investors are not about to shift 40% of their portfolio into commodity futures and REITs, for various reasons, said Steven Foresti, a managing director at Wilshire.

Instead, the Wilshire study found that shifting 5% of assets to commodity futures and 10% to REITs would boost returns by 27 basis points — more than half of the 51-basis-point return improvement from allocating 20% of assets each to commodity futures and REITs.

The result not only boosts expected return but also helps hedge against inflation risk, Mr. Foresti explained. "So you really get a double benefit when understanding the role inflation has in a portfolio."

But even supporters of commodity futures recognize that institutions might be wary of investing at the top. "We always worry about people chasing the hot stock, the hot asset class," Mr. Idzorek said.

Investing in commodity futures also gets into some arcane arguments on where the return premium comes from. Experts say it comes from three or four sources, but a key ingredient is how much of a premium investors get for taking the risk off the hands of sellers of futures, typically commodity producers.

Michael Rosen, principal at Angeles Investment Advisors, Santa Monica, Calif., said if one accepts that there's no long-term appreciation for commodities and that the risk premium for futures contracts is disappearing, it makes little sense to make a permanent allocation.

Instead, it makes more sense to move in and out of commodities tactically, as conditions warrant, he said. Some Angeles clients use commodity futures in combination with other inflation hedges, he noted.

Plus, at some point commodity prices will drop — possibly on the order of 30%, Mr. Rosen said. "The law of supply and demand has not been repealed. Commodity prices have been highly cyclical."