Perhaps some of you may recall a scene from the movie "Trading Places" where actor Eddie Murphy is sitting at an office conference room table before what he mistakenly thinks is breakfast. After all, the items lined up in front of him are a glass of orange juice, a cup of coffee, a few strips of bacon and some toast. However, his "mentors" patiently explain to him that these products are commodities, and the rights to buy or sell a specified amount of these commodities at a specified price at a specified time in the future (commodity futures) are traded daily on the commodity exchanges.

You may also remember the scenes in the movie from the floor of the commodity exchange with the hordes of traders shouting and frantically gesturing with their hands in what can only be seen as barely controlled chaos. And that was a fairly good approximation of what trading in the "pits" is really like as we see frequently on investment news programs.

It may be images like those that are responsible for commodities getting a bad name with most investors. Make no mistake; investing in individual commodity futures can be quite volatile and dangerous to your financial health. Unpredictable events such as a freeze in Florida, a drought in the Midwest, or new supply quotas by OPEC can all send prices moving sharply in one direction or the other. And the impact of that volatility on your investment is magnified because in purchasing (or selling) a commodity future you are in essence, buying on margin, putting up a small amount of money to control a much larger value of a particular commodity. In the movie, Mr. Murphy learns this lesson well as he witnesses one fortune made and another lost. While life is different from the movies, the potential for large gains or losses is quite real.

What Commodities Have To Offer
At this point, commodity futures probably don't sound like a great idea for your portfolio, but they actually have some very attractive features for growth-oriented investors.

The first thing to keep in mind, is that just as with individual stocks, the volatility inherent in any individual commodity future can be substantially reduced by buying a well diversified basket of futures. In fact, according to research by Geert Rouwenhorst, Professor of Finance and Deputy Director of the International Center for Finance at Yale University, over the past 45 years, such a basket of commodities (actually an equal weighted index of all commodity futures) had about the same volatility as the S&P 500.

Professor Rouwenhorst's research reveals two other important aspects of commodity futures over the past 45 years: in addition to volatility similar to the S&P 500, they have also generated returns similar to that broad stock index; and most important for commodities role in a portfolio, those returns were negatively correlated to the stock market. That negative correlation means that, in general, when stocks are performing poorly, commodities tend to perform well (and vice-versa).

In light of these features, substituting some of the stock exposure in a portfolio with commodity exposure should, over time, reduce overall portfolio volatility (because of their negative correlation) without diminishing expected returns.

Commodities vs. Inflation
One other aspect of commodities with which you are probably familiar is their strong correlation to inflation. Rising commodity prices and rising inflation tend to go hand-in-hand. In fact, it is this relationship to inflation that accounts for a large part of the negative correlation of commodity returns to stock returns.

While stocks are reasonably good inflation hedges over long time periods, over shorter spans, commodities fare much better since commodity futures quickly adjust to changing inflation expectations. In a rising inflation environment, businesses, on the other hand, at first are confronted with rising costs and shrinking profit margins before they can either improve productivity or increase the prices of their products.

Because of this, in periods of rising inflation such as we are currently experiencing, some exposure to commodities is particularly valuable. Moreover, commodity prices tend to move in cycles lasting up to 18 years - so even though commodities have been strong for a couple of years, we may still have many more years of strong commodity markets.

Source: Reuters

As shown in the chart above, commodities tend to move in long cycles of performance. Commodity futures went essentially nowhere for 15 years (1957-1971); then moved sharply higher for 9 years (1972-1980); then trended down (with a lot of volatility) for the next 21 years (1981-2001). The most recent move upwards is just two+ years old having begun in 2002.

This is not to say, of course, that commodity prices will be moving ever higher for the next several years; they will rise and fall as inflation expectations go through similar swings. After peaking in mid-March, commodity prices have retreated as inflation fears have eased somewhat.

There is debate among analysts on whether we have more to fear from deflation or inflation in the immediate future, but the fact remains that inflation is still rising and having some protection against inflation in a portfolio is a good idea.

Our Commodity Exposure
Recognizing the value of having the aforementioned attributes of commodities in a portfolio, while aware of the risks involved, we have a modest exposure to PIMCO Commodity Real Return for most of our growth-oriented clients. We first invested in the fund in March of 2003 and it has rewarded us with a significant return since then. (Over the last several weeks, the fund has fallen along with commodity prices as noted above, but it remains one of the strongest performers for 2005 to date.)

Commodity Real Return is unique in that it actually "plays" inflation in two ways. Manager John Brynjolfsson uses a small percentage of the fund's assets (currently about 17%) to purchase index linked derivatives, commodity swap agreements and futures that gives him 100% exposure to the investment return of the Dow Jones-AIG Commodities index. All of this is then backed with a majority position in TIPS (treasury inflation protected securities) and other fixed income instruments.

The underlying majority position in TIPS and other fixed income securities is there to increase the return of the portfolio above that of the DJ-AIG index. Since both are positively correlated to inflation, in theory, the portfolio should perform very well during inflationary periods.

 

Pimco Commodity Real Return Performance (YTD 4/30/05)
	YTD (%)	1-Year (%)	Inception* (%)
Pimco Commodity Real Return	6.6	13.2	99.8
S&P 500	-4.0	6.3	22.8
Bond (Lehman Agg Bond Index)	0.9	5.2	16.4
Dow Jones AIG Commodity Index	6.3	2.9	53.0
*inception = 6/28/02