Commodities are the necessary building blocks of the world. Glance around you – commodities are what the world needs to live and prosper and are everywhere you look. The world’s seven billion people need resources, and that’s why we recommend investors consistently allocate a portion of their portfolio to a natural resources investment.
Not every investment is the same, though. Even within the commodities space, when looking at measures such as correlation, performance and risk, two indexes can have very different effects on a portfolio’s results.
Take two popular commodity-related indices for example, the Dow Jones-UBS Commodity Index (DJUBS) and the Morgan Stanley Commodity Related Index (CRX).
The DJUBS is made of futures contracts on various physical commodities that represent major commodity sectors such as agriculture, energy, grains, metals, livestock and precious metals. Basically, futures are contracts between a buyer and seller, where the buyer agrees to purchase a specific commodity for a specific price and specific time in the future.
The CRX is comprised of stocks involved in commodity related industries, such as energy, non-ferrous metals, agriculture and forest products.
Yet, while both indices are diversified across various commodities, their correlations to the overall market differ.
Take a look at the matrix looking at 10 years of data. The table lists the S&P 500 Index, which represents the overall US stock market, and the two commodity indices. When two asset classes or investments are perfectly correlated to each other, their performance moves are in sync and they have a correlation of 1; 0 means that the two investments have no correlation to each other.
Over the past decade through June 30, 2012, you can see the DJUBS and the S&P 500 have had a correlation of 0.80. The CRX and the S&P 500 had a correlation of 0.62. This means the CRX is less correlated to the overall market than the DJUBS.
And why is a low correlation beneficial? In a diversified portfolio, it can reduce an investor’s volatility.
In the article “Material World,” Financial Planning found that a low correlation is a “valuable feature” for natural resources mutual funds. When author Craig Israelsen compared the correlation to the overall market to the 10-year annualized returns of 18 natural resources funds with 10 years of performance records, “a clear pattern” emerged. “Natural resources funds with lower correlations (that is, closer to zero) had better performances during this span,” he says.
Over the past 10 years, this pattern was prevalent in the CRX, as commodity producers far outperformed the index of commodity futures.
How to Optimize Your Portfolio with Commodities
So how do correlations and long-term performance translate to your portfolio? One way to look at this would be to create an efficient frontier, which charts a range of allocations to commodities and the overall market to see which portfolio would be most efficient, i.e., which portfolio enhances returns without adding risk.