How Commodities Can Help a Portfolio

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How Commodities Can Help a Portfolio

Postby larryswedroe » Wed May 22, 2013 3:04 pm

It helps to see things in the whole as this post points out.


http://www.cbsnews.com/8301-505123_162-57585316/how-commodities-can-help-a-portfolio/Hope you find it helpful

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Re: How Commodities Can Help a Portfolio

Postby rmelvey » Wed May 22, 2013 3:21 pm

Larry,

I was wondering about your thoughts about choosing which piece of the portfolio to carve commodities out of. You showed that it has low correlation to both stocks/bonds, and you mention that it is a great bond hedge for retirees, but you choose to take it out of equities in this example.

So for example, let's say a retiree has 75% 5 year Treasuries and 25% Equities. How would they fold in commodities? Personally, I would ask myself what the risk parity allocation would be, and then tilt towards equities on top of that risk parity, but what are your thoughts?

Edit:
FWIW I calculated that an allocation of 20% stocks, 20% commodities, and 60% 5 year is the risk parity allocation (using the equal risk contribution formula).
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Re: How Commodities Can Help a Portfolio

Postby Clearly_Irrational » Wed May 22, 2013 3:56 pm

If you're going to add commodities I like something like GCC, which is an equal weight index since it tends to be less overpowered by oil and other energy commodities. In general I prefer something less pro-cyclical so I find that focusing on gold as my commodity allocation does more of what I wanted which is to zig when stocks zag. Of course, if you want to offset your bonds then of course commodities are actually better. Personally I find offsetting my stocks to be a higher priority.

3yr CORRELATIONS
--------------------
GCC vs SPY 0.54
GLD vs SPY 0.09

GCC vs BND -0.23
GLD vs BND 0.13
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Re: How Commodities Can Help a Portfolio

Postby zotty » Wed May 22, 2013 4:03 pm

I've found that holding a diversified collection of Gibson Les Pauls, well kept amplifiers, and analog pro-audio is an excellent diversifer for stocks & bonds. Rebalancing can be fun.

Just kidding, sort of. These "hard assets" may be less liquid, but they are certainly less flawed than commodity derivatives. contago bleed, counterparty risk, heavy turnover.

They have everything indexers love to hate.
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Re: How Commodities Can Help a Portfolio

Postby Clearly_Irrational » Wed May 22, 2013 4:20 pm

zotty wrote:I've found that holding a diversified collection of Gibson Les Pauls, well kept amplifiers, and analog pro-audio is an excellent diversifer for stocks & bonds. Rebalancing can be fun.

Just kidding, sort of. These "hard assets" may be less liquid, but they are certainly less flawed than commodity derivatives. contago bleed, counterparty risk, heavy turnover.

They have everything indexers love to hate.


I would classify those along with "Art & Collectibles". They're decent holdings, but they are illiquid and definitely not "financial assets". Ignoring the aesthetic value, is holding a Monet or Rembrandt a good investment? I argue that it is, but that you need to understand how to value your holdings and it depends on your total wealth. If you have enough that you can afford to tie up some value in illiquid holdings there are a number of different investments that will pay you a premium for that, timber land for example.
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Re: How Commodities Can Help a Portfolio

Postby larryswedroe » Wed May 22, 2013 5:30 pm

rmelvey
IMO without question should come from the stock side. Reason is simple
Why do you want to even consider commodities? Answer, hedge against certain risks, portfolio insurance if you will. Idea is to dampen volatility, cut tail risks
That gives you the answer.
If you take from stock side you accomplish the objective. Take it from bonds and you raise volatility, not lower it. One reason is that you added more risk of stocks and CCF both going down due to demand shocks which hit both.

I hope that is helpful

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Re: How Commodities Can Help a Portfolio

Postby am » Wed May 22, 2013 9:19 pm

Are there any low cost options available that avoid problems with rolling contracts over?
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Re: How Commodities Can Help a Portfolio

Postby rmelvey » Wed May 22, 2013 9:25 pm

am wrote:Are there any low cost options available that avoid problems with rolling contracts over?


am,

Concerns about high expense ratios, contango, and hedge funds front running the ETFs led me to gold. IAU can be had for .25 bps. GTU is another great CEF option, and you get a better tax treatment (not technically a collectible). Physical coins in a safety deposit box can also be economical if you already have the box.

Yes gold has less "diversity" than some of the industrial commodity indices, but gold also has a lower correlation to the stock market because it has a monetary element to it.
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Re: How Commodities Can Help a Portfolio

Postby magician » Thu May 23, 2013 7:54 pm

Clearly_Irrational wrote:. . . does more of what I wanted which is to zig when stocks zag.

What, exactly, does this mean?
Simplify the complicated side; don't complify the simplicated side.
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Re: How Commodities Can Help a Portfolio

Postby Clearly_Irrational » Fri May 24, 2013 12:42 pm

magician wrote:
Clearly_Irrational wrote:. . . does more of what I wanted which is to zig when stocks zag.

What, exactly, does this mean?


Diversification in general and Modern Portfolio Theory in particular rely on the idea of holding divergent assets. The most classic example is that Stocks don't move the same as bonds. You can explore this idea on a fundamental basis, stocks are equity vs. bonds are debt and so have different drivers, or you can look at it mathematically, say using Pearson's correlation for example.
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Re: How Commodities Can Help a Portfolio

Postby jasonlitka » Fri May 24, 2013 1:34 pm

zotty wrote:I've found that holding a diversified collection of Gibson Les Pauls, well kept amplifiers, and analog pro-audio is an excellent diversifer for stocks & bonds. Rebalancing can be fun.

Just kidding, sort of. These "hard assets" may be less liquid, but they are certainly less flawed than commodity derivatives. contago bleed, counterparty risk, heavy turnover.

They have everything indexers love to hate.


I prefer vacuum tubes from the 60's. :)

They hold value pretty well, even when used, and, in times of short supply (which is pretty much always), can be worth well more than you put into them. I've sold a few Mullards off for more than twice what I paid. You'll need to pry the Telefunken CCa tubes out of my cold, dead hands though. Never giving those up.
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Re: How Commodities Can Help a Portfolio

Postby RNJ » Sat May 25, 2013 8:25 am

Larry -

Thanks as always for your post. Getting into the nitty-gritty, does the use / utility of commodities in a portfolio change if the portfolio is tilted towards small and/or value, or if there is a stand-alone allocation to emerging markets (as opposed to a Total International approach)?

Thanks!
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Re: How Commodities Can Help a Portfolio

Postby OverTheHill » Sat May 25, 2013 9:59 am

I think Rick Ferri has already answer this point quite well: viewtopic.php?f=10&t=116869
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Re: How Commodities Can Help a Portfolio

Postby RNJ » Sat May 25, 2013 4:54 pm

OverTheHill wrote:I think Rick Ferri has already answer this point quite well: viewtopic.php?f=10&t=116869



Thanks OTH. I've been following Rick's thread but, as you can see, I have a fairly specific question that was not addressed. Rick's position is clear - basically, "don't own commodities" - so there really isn't a point to posting my question on that thread. With respect to commodities / CCFs as an investment, I am agnostic, and can certainly see the logic of Rick's position. However, to my mind, this shouldn't necessarily discount the use and utility of CCFs in the context of a portfolio - Larry's point, as I understand it.

As my portfolio is tilted towards small and value (I am not alone here) with a 50/50 US/Int split (I know your feelings about this), I am curious if the use and utility of CCFs changes in a tilted portfolio. Hence my question.

Thanks, again.
Last edited by RNJ on Sun May 26, 2013 2:53 am, edited 1 time in total.
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Re: How Commodities Can Help a Portfolio

Postby louis c » Sat May 25, 2013 5:24 pm

From the Greenhaven site, reference GCC:

Management Fee 0.85%
Estimated Futures Brokerage Fee and Other Expenses* 0.20%
other fees apply**
There is no free lunch.
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Re: How Commodities Can Help a Portfolio

Postby James2 » Sat May 25, 2013 6:20 pm

I went and used Yahoo Finance to review some broad commodities market ETFs and saw that the 5 yr return was negative, I wonder where the commodity portion of a portfolio should be placed (if not in "hard" assets like some other posters)... Maybe I'm missing something as far as fund alternatives?

http://finance.yahoo.com/etf/lists/?mod ... 24BB%24%24
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Re: How Commodities Can Help a Portfolio

Postby larryswedroe » Sat May 25, 2013 9:59 pm

RNJ
few quick thoughts
1) value stocks tend to do better in inflation--tend to be more highly leveraged and leverage benefits from inflation
2) if you use the tilts (and their higher expected returns) to lower exposure to beta (so portfolio has same expected returns) then you have less need to consider CCF
3) those with low beta exposure and TIPS or relatively short term bonds have less/little need to consider CCF, it's those that have high stock exposure and longer term nominal bonds that should more strongly consider CCF

Hope that helps
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Re: How Commodities Can Help a Portfolio

Postby RNJ » Sun May 26, 2013 2:49 am

Larry -

That helps a lot - thank you!
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Re: How Commodities Can Help a Portfolio

Postby larryswedroe » Sun May 26, 2013 8:36 am

RNJ
Another thought, if you have low equity allocation you often don't have room in your tax advantaged accounts to hold all the bonds you want to hold--and CCF is tax inefficient, and unless in lowest brackets should only be held in tax advantaged accounts. Thus that's another consideration--should you use up the limited tax advantage space.
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Re: How Commodities Can Help a Portfolio

Postby pop77 » Sun May 26, 2013 9:36 am

Read the article. There seems to be some "Voodoo Math" in the article. Here I quote.

"We begin with the 50 percent allocation to the S&P 500 which returned 8.2 percent, so its weighted impact on the portfolio was 4.1 percent. The 40 percent allocation to the 20-year Treasury earned 8.6 percent, so its weighted average impact was 3.44 percent. Combined, we have accounted for 7.54 percent of the portfolio's 9.0 percent return. Thus, the 10 percent allocation to the S&P GSCI contributed the remaining 1.46 percent. Given the S&P GSCI's 10 percent allocation, the weighted average impact on the portfolio's return was 14.6 percent, or 11 percent greater than its return when viewed in isolation"


IMHO this piece is highly misleading. Let us take the 60% Stocks/40% Bonds example. This combination produced 9.2% return over ten years. Now one could argue that as S&P 500 produced 8.2% , 50 % of it is 4.1%. As bonds produced 8.6%, 40% of it 3.44% giving us a total of 7.54%. Does that mean that the last 10% of the stock allocation contributed 1.66% so returned 16.6%?

I still have the key question of investing in commodities, Does commodities produce long term wealth accumulation? Commodities also have the problem of cost of following a commodities index in any fund that tries to mimic it. In case of stocks, one could just buy and hold a set of stocks in an index for 10 years, there is no way to do this for commodities. The commodity index funds often have to buy the commodity futures and have to roll them periodically incurring costs. Earlier, the funds use to hold TIPS and Bonds as collateral that gave them the return to cover the costs of buying the futures, not the case any more. So there may not be a real way to hold commodity indexes in a low cost way for long terms of time.
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Re: How Commodities Can Help a Portfolio

Postby larryswedroe » Sun May 26, 2013 9:56 am

pop
There's no voodoo
This is how you see how an addition of an asset impacts the return of the portfolio. What is the weighted average return of the components --considering the assets you start with and take their returns and then see what return the rest had to have to provide the total result. You can do the same thing with starting from 100% stocks and adding say 10% bonds. You'll see that the portfolio return will be higher than the weighted average return of the components--assuming you rebalance, otherwise no diversification return. CCF provided higher than its individual return due to the components

As to the costs of running a fund. Both DFA and PIMCO funds have outperformed their benchmarks since inception even after ALL costs. This was relatively easy to predict and it's happened. I pointed this out long ago. The reason is that the indices roll on 5 consecutive days that are known in advance --transparent-and active players know what the indexers must do so they can exploit them. The well known Russell 2k reconstitution effect was the same thing--costing indexers about 2% a year in that index. The same thing happens here. Both PIMCO and DFA avoid the roll dates when trading and have added about that same amount to returns, or more by simply doing that. Then you can avoid the front month which is often the most expensive to trade. Instead can trade where cheapest to trade. Simple strategies can allow a fund to outperform an index--showing there are negatives to pure indexing and costs to avoid tracking error. In some cases the costs are very low and in others they are high. CCF is case of high costs.

I don't know why you made this statement because it's simply incorrect
Earlier, the funds use to hold TIPS and Bonds as collateral that gave them the return to cover the costs of buying the futures, not the case any more.
It should be relatively easy to outperform 3 month bills, the collateral in the index, without taking much term or credit risk. The short end of the curve is generally the steepest and best rewarded, so just going out a few years gets you fairly large premium with little more risk, and you can buy agencies and high quality investment grade corporates and also pick up yield there as well.
That is what DFA does, using its ST extended credit quality fund.

This shows that if a fund had been live it likely would have outperformed the indices, not underperformed them. At least a well run one. And thus the data UNDERSTATES the benefits one might have achieved, not overstates it.


Hope that is helpful

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Re: How Commodities Can Help a Portfolio

Postby pop77 » Sun May 26, 2013 12:35 pm

Thanks for the reply Larry. What I was trying to present is a situation where an investor has invested has invested 90% of their assets (50% Stocks and 40% Bonds). Now he or she has to make a decision as to how to invest the remaining 10%. It can either go into stocks, bonds or commodities. Going by your logic, if the 10% invested in commodities produces 1.46% due to diversification, I could argue that the 10% if invested in stocks could have produced the 1.66% return.

It is possible that commodities give a portfolio diversification benefits but I am getting frustrated by their performance so far. I started investing in them (PCRDX and HACMX) from 2010 and so far that has been the lowest performing asset class. May be my starting point was wrong and I need more time. Based on the discussion on the topic so far, I am trying to make an investing decision as to whether I should abandon them altogether or add more (currently only 3% of my portfolio) as they are the lowest performing relative to all other asset classes. I am ready to invest and hold them for long period (say 10 years) if they provide long term positive returns. As you have explained may be rebalancing is the key here. As all the other asset classes has run up in prices relative to commodities may be I should put my incremental capital in commodities.

I still keep wondering, that all the other asset classes have their own cash flow (stocks have their earnings and dividends that grow, bonds pay interest and real estate gets rent) so over a period of time you accumulate wealth. How does that work with reference to commodities? Is it that the cost of producing the commodities (mining, drilling etc)goes up over time and because of that commodities accumulate wealth?
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Re: How Commodities Can Help a Portfolio

Postby larryswedroe » Sun May 26, 2013 1:06 pm

pop
That is not the way to look at it. What you want to look at is start with your proposed allocation. In that case not 90% stocks but either 100% stocks or 90% stocks and 10% bonds. Then add say 10% CCF by first taking from stocks and then from bonds and you can see the impact on the portfolio.

As to performance so far. As I showed, they have underperformed stocks and bonds by wide margins over last 20 years and yet a disciplined rebalancer would have ended up with a higher SR--and that is using the indices, when we now see that a well run fund can likely outperform. And this was in period when the insurance wasn't needed as we did not have unexpected inflation. So you bought insurance, and paid no premium, but the risks did not show up. Now think about what might have happened if we had unexpected inflation.

When you buy CCF you should pray for poor relative returns because that likely means that the other portions of the portfolio are likely doing well, especially the bond side. It's like when you buy any form of insurance, you never want to collect on it (get a high return on your purchase).

CCF cuts tail risks, both good and bad. And if you are a risk averse investor (almost all are) then you should actually be willing to accept LOWER portfolio returns for that trade off. Historical evidence is that you have not had to do so.

And yes the key is rebalancing--if you don't then the math doesn't work as the portfolio's returns are equal to the weighted average of the components-there is no diversification benefit, no rebalancing benefit. So if you are not going to be willing to buy when CCF does poorly I would not want to hold them. Then you get the lower returns without the diversification benefit that comes from rebalancing.

As to last question, need to stop thinking about commodities as creating wealth the way stocks are expected to do--that's the problem. You need to think of them as portfolio insurance.

BTW-if you own CCF you can take more term risk--strong negative correlation there. So if you sell your CCF I would shorten up your bond portfolio a bit to compensate. That will cost you some expected return.


I hope that is helpful
Best wishes
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Re: How Commodities Can Help a Portfolio

Postby jmg229 » Sun May 26, 2013 6:39 pm

Larry, I really appreciate this article, as I currently have chosen to not include any commodities in my asset allocation and this challenges that decision. I also love that you and Rick are willing to continue to debate this issue publicly with the board. As I think through the issue, I have come across a couple of issues with the article I was hoping you could respond to.

We begin with the 50 percent allocation to the S&P 500 which returned 8.2 percent, so its weighted impact on the portfolio was 4.1 percent. The 40 percent allocation to the 20-year Treasury earned 8.6 percent, so its weighted average impact was 3.44 percent. Combined, we have accounted for 7.54 percent of the portfolio's 9.0 percent return. Thus, the 10 percent allocation to the S&P GSCI contributed the remaining 1.46 percent. Given the S&P GSCI's 10 percent allocation, the weighted average impact on the portfolio's return was 14.6 percent, or 11 percent greater than its return when viewed in isolation.


First, I am wondering why you feel as though you can attribute all of this 1.46% of return to the 10% allocation to S&P GSCI. It seems as though you could do this analysis in a different order and get different results. For example, when you look at the 60% S&P 500/40% 20-Year Treasuries, if you try to allocate the return to each part of the investment, you get (.6*8.2) = 4.92% for the S&P 500 Index and (.4*8.6) = 3.44% for a total of 8.36%, but combined their return was 9.2%, so there is a .84% rebalancing bonus between them, right? You attribute all of the bonus to the addition of commodities in your calculation to make the case that commodities contribute more to an entire portfolio than they do in isolation. While I'm not doubting that commodities do provide some bonus due to their negative correlation with practically everything else, it seems like you are ignoring the basic stock-bond interaction to overstate the case for commodities in the article.

Second, you chose a time and index where commodities returns outpaced inflation (if I'm calculating the inflation rate right, I get about 2.2% per year from 1993-2012). You accept, however, that commodities should have no expected real return, so I'm wondering if it would make more sense to run the analysis over a time period where the real return of commodities was 0 (which will involve plenty of issues with cherry-picking data, I'm sure).

Thanks again for your willingness to delve into these issues for our collective benefit.
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Re: How Commodities Can Help a Portfolio

Postby Rodc » Sun May 26, 2013 6:56 pm

That is not the way to look at it. What you want to look at is start with your proposed allocation. In that case not 90% stocks but either 100% stocks or 90% stocks and 10% bonds. Then add say 10% CCF by first taking from stocks and then from bonds and you can see the impact on the portfolio.


Larry,

With all due respect, you are missing his point regard the math.

Make it 50% vanguard TSM, 10% vanguard S&P 500 and 40% TBM for portfolio A and 50% TSM, 10% CCF, and 40% TBM for portfolio B

Use your logic on B to say what the benefit of CCFs are, just as you did.

Now repeat the exact same calculation substituting S&P 500 where you had CCF.

Which had more impact, CCF or S&P 500?
We live a world with knowledge of the future markets has less than one significant figure. And people will still and always demand answers to three significant digits.
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Re: How Commodities Can Help a Portfolio

Postby larryswedroe » Sun May 26, 2013 8:14 pm

jmg
I chose a period where CCF underperformed stocks by a wide margin, about what stocks outperformed inflation by historically
You go back further you only get better looking data
And in case of GSCI it was about 1% difference, and a well run fund should be able to make that up as I noted

Rod, not missing the point at all
It's that you start with a portfolio and see what additions do to the risk/return
And what we are trying to see is what impact commodities have on existing portfolios--and this is exactly what I did
So you could do the same thing starting with 100% CCF portfolio and add stocks or bonds and attribute all the benefit to that asset. Of course no one holds all CCF portfolio.

Example would be start 60% TSM and 40% TBM, then make it 50% TSM, 10% S&P and 40% bonds and you see what impact the S&P had
And you can then see instead what CCF would have had if you like

At any rate I could only run the data through 2011 due to a problem with a program but 93-11 adding S&P to the 60/40 meant S&P which returned 7.8 added on weighted average basis as if it added 12.8 (or 5% more)
GSCI added on weighted average basis 11.8% or about 8.5 more than its return viewed in isolation, or 3.5% larger diversification benefit than the S&P addition did.

GSCI adds more relatively speaking because of the lower correlations and higher SD giving you the greater diversification return.

Now of course you can start with S&P at 60% and add 10% TSM and you see some similar things. Of course some of the benefits come from the rebalancing between stocks and bonds as well. Not just stocks and commodities or bonds and commodities. And you can see that diversification effect when you start out with an all stock or all bond portfolio.

Again what you want to measure is how the addition of any asset impacts the risk and return of the portfolio you start with.
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Re: How Commodities Can Help a Portfolio

Postby Rodc » Sun May 26, 2013 8:48 pm

Again what you want to measure is how the addition of any asset impacts the risk and return of the portfolio you start with.


We all agree on that. The issue is getting the math correct in doing so.

Perhaps the easiest and clearly correct way to do so is forget the naive "If stocks return X% and you have 50% stocks they added X/2%..." and just compute the returns and sd for the entire stock/bond portfolio. Then do the same for the portfolio with ccfs.

The problem with the way you are doing it gives the correlation benefits between stocks and bonds to cff.
We live a world with knowledge of the future markets has less than one significant figure. And people will still and always demand answers to three significant digits.
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Re: How Commodities Can Help a Portfolio

Postby larryswedroe » Mon May 27, 2013 1:48 am

Rod

Perhaps right way to do it so not all impact is from the third asset added is to weight in my article the following way
60/40 returns 9.2% (vs weighted average of 8.3, for a diversification return for the portfolio of 0.9)

The 9.2% is what we should use to start with. So when using that for 90% of portfolio their impact (using 10% commodities) is 8.38. now subtract that from 9.0 portfolio return when adding CCF.

now I rounded those return figures to nearest 0.1 so won't be exactly correct but you get .62 so the CCF contributed as if returned 6.2%.
GSCI returned 3.8 so the return diversification there was 2.4%
For DJ UBS it was 5.4% so the return diversification was 0.8%.



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Re: How Commodities Can Help a Portfolio

Postby Call_Me_Op » Mon May 27, 2013 9:40 am

I don't like the way commodities (ex-gold) behaved in 2008. One important reason why I diversify is to avoid scenarios where most of my assets go down the tubes simultaneously. Personally, I would prefer a small allocation to gold - purchased at the right price - not to provide inflation protection (because I don't think a commodity basket does a good job at that either) - but to generally provide some diversification benefit and perhaps to hedge against a weakening of the dollar.
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Re: How Commodities Can Help a Portfolio

Postby pop77 » Mon May 27, 2013 9:42 am

As to last question, need to stop thinking about commodities as creating wealth the way stocks are expected to do--that's the problem. You need to think of them as portfolio insurance.


I think I can live with that. Let us all agree that investing in commodities is like buying insurance which is a cost not an investment. I have a house and I have home owner's insurance, similarly I could think of commodities as portfolio insurance. What do you think of other investment products like a bear fund or short bond fund as means of portfolio insurance? They are also bound to go up when everything else in the portfolio is falling. Again they by themselves won't return anything but will provide cushion when stocks or bonds are falling.
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Re: How Commodities Can Help a Portfolio

Postby larryswedroe » Mon May 27, 2013 9:44 am

Call Me OP
You may not like it but you should have expected it as commodities do poorly in demand shocks--like 1981 and 2001 before 2008. Which is why if you are going to own them you should also consider adding a bit of duration risk--which tends to perform well during such periods.

Also CCF performed about as poorly as a globally diversified and tilted portfolio--so not much if any damage done if took from stock side as I recommend--and benefited if also extended duration of high quality bonds as they did really well.

Best wishes
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Re: How Commodities Can Help a Portfolio

Postby nisiprius » Mon May 27, 2013 10:07 am

larryswedroe wrote:... need to stop thinking about commodities as creating wealth the way stocks are expected to do--that's the problem. You need to think of them as portfolio insurance.
I do not think investments should be called "insurance" (and I do not think insurance should be called "investments.")

Insurance is a contract in which an accountable party promises to do specific things if certain things happen. Some vague historical tendency for some asset to behave in certain ways isn't insurance. If it doesn't do it what you expected it to do, whom do you take to court? Wouldn't you take issue if a gold advocate called gold "insurance?"

The specific phrase "portfolio insurance" is further confusing because when I hear it I think of the crash of 1987. The term has a specific technical meaning: it refers to some complicated hedging system (having nothing to do with commodities) that failed spectacularly. I'm sure you know orders of magnitude more about what it was and what it did than I do.
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Re: How Commodities Can Help a Portfolio

Postby larryswedroe » Mon May 27, 2013 12:26 pm

nisiprius
Well you can nitpick if you like about terms. What would you call a product that cuts tail risks and hedges nominal bond risk well and hedges some of risks of stocks well as well?
I would call it an investment in a product that hedges risks--that is insurance.

BTW-there's another investment that has negative expected real returns that acts as insurance that most like-they are called TIPS --with now negative real returns on most parts of the curve and typically lower expected return than nominal bonds--so why buy them? Because they have insurance feature, a hedge against risk of unexpected inflation
Best wishes
Larry
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Re: How Commodities Can Help a Portfolio

Postby avalpert » Mon May 27, 2013 10:33 pm

larryswedroe wrote:nisiprius
Well you can nitpick if you like about terms. What would you call a product that cuts tail risks and hedges nominal bond risk well and hedges some of risks of stocks well as well?
I would call it an investment in a product that hedges risks--that is insurance.

BTW-there's another investment that has negative expected real returns that acts as insurance that most like-they are called TIPS --with now negative real returns on most parts of the curve and typically lower expected return than nominal bonds--so why buy them? Because they have insurance feature, a hedge against risk of unexpected inflation
Best wishes
Larry


If you are trying to be precise and accurate with your terms I believe it is more proper to say insurance is one means of hedging risk but not all hedges are insurance. Nisprius is right, insurance in a formal sense involves a counterparty who agrees to compensate you under specified circumstances; in this situation you do not have that. TIPS are closer to insurance in that the government is acting as a counterparty who agrees to compensate you in line with inflation, but I would still say that at best it 'acts like insurance' rather than it is insurance.

You could say that the precision in terms doesn't matter - you are just trying to convey an idea of the role commodities are playing. But I would argue that in that context it is extremely important to differentiate as many will expect something that you claim is 'insurance' to come with a guarantee of performance that commodities just can't provide.
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Re: How Commodities Can Help a Portfolio

Postby cheepsk8 » Mon May 27, 2013 11:47 pm

Thank you for the article. You've gotten me very interested in further diversifying my portfolio. Any commodities funds you can recommend? One that adheres to the bogleheads philosophy of no loads, low expense ratio, no extra fees, etc... Thanks in advance.
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Re: How Commodities Can Help a Portfolio

Postby larryswedroe » Tue May 28, 2013 9:01 am

avalpert
I think I have made very clear that CCF acts like portfolio insurance. When answering here don't have the time to be as precise as some might like--actually have a life and full time job
Personally I think this is really big time nitpicking, but just my personal opinion
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Re: How Commodities Can Help a Portfolio

Postby Rodc » Tue May 28, 2013 5:17 pm

larryswedroe wrote:Rod

Perhaps right way to do it so not all impact is from the third asset added is to weight in my article the following way
60/40 returns 9.2% (vs weighted average of 8.3, for a diversification return for the portfolio of 0.9)

The 9.2% is what we should use to start with. So when using that for 90% of portfolio their impact (using 10% commodities) is 8.38. now subtract that from 9.0 portfolio return when adding CCF.

now I rounded those return figures to nearest 0.1 so won't be exactly correct but you get .62 so the CCF contributed as if returned 6.2%.
GSCI returned 3.8 so the return diversification there was 2.4%
For DJ UBS it was 5.4% so the return diversification was 0.8%.



Larry


Larry,

Thanks.
We live a world with knowledge of the future markets has less than one significant figure. And people will still and always demand answers to three significant digits.
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Re: How Commodities Can Help a Portfolio

Postby muntz » Sun Jun 02, 2013 1:47 pm

Thanks for the article Larry. I own PCRDX, but still have a nit to pick.

You used indices in your analysis rather than investible funds. What funds do you recommend one own to get commodity exposure and have you run the numbers with these?
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Re: How Commodities Can Help a Portfolio

Postby nisiprius » Sun Jun 02, 2013 3:01 pm

Don't follow it regularly, happened to see it in the library... March, 2013, Consumer Reports Money Advisor:
Worth the trouble?

We created two hypothetical portfolios that were worth $100,000 at the beginning of 2008. We invested one in an traditional mix of 60 percent stocks and 40 percent bonds. The other contains 51 percent stocks, 34 percent bonds, and 15 percent commodities, split evenly among three ETFs: the broad-based iShares S&P GSCI Commodity-Indexed ETF, SPDR Gold Shares, and iShares Global Timber and Forestry. During the past five years there was little discernible difference between the two portfolios; volatility wasn't reduced, nor were returns greater.
There is a pretty convincing chart, indeed showing "no discernible difference."

The text precedes the test results by saying "To see if Ibbotson's 2006 research would still hold up in recent years..." and follows it by saying "Blame 'risk on, risk off' investing--the shorthand professional traders use to describe the behavior of the stock and bond markets in the past few years.... Currently, it appears that commodities are not marching to their own beat, as usual, but instead are moving more in sync with stocks."

In the same issue: another article, "Passive investing pays off--again."
Last edited by nisiprius on Sun Jun 02, 2013 3:11 pm, edited 2 times in total.
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Re: How Commodities Can Help a Portfolio

Postby rmelvey » Sun Jun 02, 2013 3:11 pm

nisiprius wrote:March, 2013, Consumer Reports Money Advisor:
Worth the trouble?

We created two hypothetical portfolios that were worth $100,000 at the beginning of 2008. We invested one in an traditional mix of 60 percent stocks and 40 percent bonds. The other contains 51 percent stocks, 34 percent bonds, and 15 percent commodities, split evenly among three ETFs: the broad-based iShares S&P GSCI Commodity-Indexed ETF, SPDR Gold Shares, and iShares Global Timber and Forestry. During the past five years there was little discernible difference between the two portfolios; volatility wasn't reduced, nor were returns greater.
There is a pretty convincing chart, indeed showing "no discernible difference."

The text precedes the test results by saying "To see if Ibbotson's 2006 research would still hold up in recent years..." and follows it by saying "Blame 'risk on, risk off' investing--the shorthand professional traders use to describe the behavior of the stock and bond markets in the past few years.... Currently, it appears that commodities are not marching to their own beat, as usual, but instead are moving more in sync with stocks."


nisi,

Why would you expect commodities to do well in a deflationary financial crisis? Bonds and stocks traded in tandem in real terms during the 1970s, but that doesn't mean you shouldn't hold bonds IMO.

I think the real issue is that investors are trained to look at correlation because it can be quantified, but a portfolio that is diversified based off of causation is more likely to be robust out of sample.

By causation I am referring to what effect the state of the economy has on asset prices... Let's imagine the aggregate supply and aggregate demand curves.

Image

*If the aggregate supply curve shifts left, both stocks and bonds are going to do terribly. Commodities will save your bacon.

*If aggregate demand shifts left, commodities and stocks will tank, but safe fixed income will do well.

*If aggregate supply shifts right, stocks and bonds will both do well, commodities will suffer.

*If aggregate demand shifts right stocks and commodities will do well, but high quality bonds will suffer.
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Re: How Commodities Can Help a Portfolio

Postby nisiprius » Sun Jun 02, 2013 3:17 pm

rmelvey wrote:nisi, Why would you expect commodities to do well in a deflationary financial crisis? Bonds and stocks traded in tandem in real terms during the 1970s, but that doesn't mean you shouldn't hold bonds IMO.
I don't care if they traded in tandem, I use bonds as bonds, not as high-volatility low-correlation stock diversifiers.
I think the real issue is that investors are trained to look at correlation because it can be quantified, but a portfolio that is diversified based off of causation is more likely to be robust out of sample.
Hey, I'm just reporting what I read, take it up with Consumer Reports Money Advisor. But the thing is: either you have to believe there are simple stay-the-course strategies that just work, or you believe that you need to be agile and understand the markets and do some kind of white-water slalom through them. Well, in the first place, I can't do that, and in the second place, I don't see much evidence that experts can.

"Causation" would be great if you knew what caused what, but I'm not convinced you do. I don't "expect" much of assets, because my observation is that whenever I check out statements about how various investments "tend to" act--even statements with "causality" behind them--it usually turns out that they haven't actually done what they are said to do, not with any dependability or consistency. Typically what happens is that there was one beautiful shining moment when they dramatically showed that behavior, like REIT Index going up in 2000-2002 when stocks in general were going down--and then no repeat performance.

Consumer Reports may not be the brightest bulb in the investment universe but they're honest and they don't sell investments; if it was obvious that 2008-2013 shouldn't count, I guess they missed the obvious.
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Re: How Commodities Can Help a Portfolio

Postby rmelvey » Sun Jun 02, 2013 3:22 pm

nisiprius wrote:
rmelvey wrote:
nisiprius wrote:March, 2013, Consumer Reports Money Advisor:
But the thing is: either you have to believe there are simple stay-the-course strategies that just work, or you believe that you need to be agile and understand the markets and do some kind of white-water slalom through them. Well, in the first place, I can't do that, and in the second place, I don't see much evidence that experts can.


You can passively hold CCF or gold. I have a target asset allocation that includes gold, and so i will be buying more if it keeps dropping to restore my asset allocation. I have no idea what gold is going to do, nor do I really care, because it is part of a broader diversification plan. My plan is an extremely simple stay-the-course strategy. It just holds an asset that many posters here happen to disparage.

I do look at how the economy affects asset markets, but not in an attempt to time them. The study of the economy is to inform me of how my portfolio would respond in different environments, so that I can be ready for them and already be diversified for it because I am terrible at making predictions :D
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Re: How Commodities Can Help a Portfolio

Postby OverTheHill » Sun Jun 02, 2013 3:54 pm

I find that it usually makes sense to ignore anyone who says that they "know" how to make money by any method other than working for it.
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Re: How Commodities Can Help a Portfolio

Postby Bradley » Sun Jun 02, 2013 3:56 pm

muntz wrote:Thanks for the article Larry. I own PCRDX, but still have a nit to pick.

You used indices in your analysis rather than investible funds. What funds do you recommend one own to get commodity exposure and have you run the numbers with these?



Larry has posted his preference for PCRIX. Warning! Do not consider this as “insurance” as is often referred to on this forum. In 2008 the total market measured by VTI declined 36.98, PCRIX lost 43.33%, in fact over the past 5 years the total market fund has outperformed PCRIX by 11.38% a year. Anyone using commodities as “insurance” should cancel their policy. What good is "insurance" if it is not there when you need it?

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Re: How Commodities Can Help a Portfolio

Postby larryswedroe » Mon Jun 03, 2013 12:38 pm

Unfortunately Bradley thinks that if you buy homeowner's insurance but not flood insurance and you lose your house to a flood that homeowner's policies are bad, they don't work

CCF protect/hedge against bond risks very well and protect, as I have explained many times here and also in my books and even shown tables to illustrate the point, against SOME but not stock risks. They protect against supply shocks, not demand shocks. Which is the main reason why you take the CCF allocation from the stocks --because sometimes the correlations are positive.

With that said, as I have also pointed out, in demand shocks, when both CCF and stocks do poorly, longer term safe bonds do exceptionally well, so if you are going to add CCF you should also consider adding some term risk to hedge the stock side further. Had you done that in 2008 you would have been better off than if you did not add CCF, as they did no worse than a diversified global stock portfolio and the bond side would have done extremely well--which is exactly what I did and assume others did as well

Best wishes
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Re: How Commodities Can Help a Portfolio

Postby rmelvey » Mon Jun 03, 2013 1:23 pm

nisiprius wrote:"Causation" would be great if you knew what caused what, but I'm not convinced you do. I don't "expect" much of assets, because my observation is that whenever I check out statements about how various investments "tend to" act--even statements with "causality" behind them--it usually turns out that they haven't actually done what they are said to do, not with any dependability or consistency.


You don't agree with the logic behind the graph that I presented? I understand skepticism, but it feels almost more like cynicism. If you have a logical argument for why the curves shifting wouldn't result in the corresponding movements I outlined, than I would be extremely interested so that I could better understand how to diversify my portfolio.

Asset markets respond to changes in the economy. These assets aren't just floating around in isolation. Greedy investors are constantly repricing them based off expectations about changes in the economy. Yes there are speculative overlays that distort things, but ignoring the affect the economy has on different assets doesn't seem reasonable. Once again, I am not talking about timing markets, but understanding them so that you can be appropriately diversified according to your risk tolerance.
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Re: How Commodities Can Help a Portfolio

Postby Bradley » Mon Jun 03, 2013 2:27 pm

larryswedroe wrote:Unfortunately Bradley thinks that if you buy homeowner's insurance but not flood insurance and you lose your house to a flood that homeowner's policies are bad, they don't work

.......... in demand shocks, when both CCF and stocks do poorly, longer term safe bonds do exceptionally well, so if you are going to add CCF you should also consider adding some term risk to hedge the stock side further. Had you done that in 2008 you would have been better off than if you did not add CCF,...............--which is exactly what I did and assume others did as well

Best wishes
Larry



There has been no mention of home insurance so lets not muddy the discussion.

Portfolio insurance has a meaning in finance and it has nothing to do with CCFs. Referring to the addition of CCFs to a portfolio as "insurance" is not only misleading it is just plain silly.


Definition of 'Portfolio Insurance'

A method of hedging a portfolio of stocks against the market risk by short selling stock index futures.




In addition, below is from the NYT article on the Larry portfolio in which you advocate one year T bills. There are many other postings in which you recommend short term bonds especially when holding low equity allocations. You co-authored a paper in the Journal of Investing in which you recommended long term bonds IF you held high equity allocations. Your current post appears to contradict those previous positions. Specifically you claim that in 2008 you added CCF and term risk(longer term bonds).


“all you would have needed to do was put 32 percent of your money in a fund mimicking the United States stock index of small and value companies that Mr. Fama and Mr. French developed. Then you’d put the other 68 percent of your money in one-year Treasury bills.
The execution is where this gets a little complicated. Mr. Swedroe, who invests this way with his own money, and BAM use small-cap value funds from, among others, Dimensional Fund Advisors,”


Did you actually add CCFs to your portfolio in 2008?

Did you actually add term risk to your portfolio in 2008?

Or did you mean to say you hold CCFs and long term bonds as part of your strategic allocation?

Some may take your statement, which is exactly what I did and assume others did as well as an all clear to make changes to their portfolio in reaction to changing market conditions which I sure that was not your intended advice.

Thanks,
Bradley
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Re: How Commodities Can Help a Portfolio

Postby larryswedroe » Mon Jun 03, 2013 4:51 pm

Bradley
First I wrote about this issue long before the financial crisis and explained exactly what I said above
Second, the home analogy is exactly the point you don't seem to get. you buy insurance for the type of risks you wish to protect. Some insurance hedge some types of risks, not all. Like a home policy wont protect you against flood or earthquake, if you want that protection you buy that type insurance
Third, as I have explained many times here CCF hedges bond risks very well, never a down year when bonds were down, and correlation is strongly negative. But they only hedge SOME stock risks (like the home analogy hedging fire but not flood), hedging supply shocks not demand. You want to hedge demand shocks you buy longer term very safe bonds. So the explanation is that you add CCF and extend bond maturity since that combo works well together
And yes as those who follow the board here know I owned CCF and add maturity before the crisis and recommended those considering adding CCF do the same, and have consistently said so, and I pointed out how wrong it was to say CCF failed in 2008 as you have implied when it did exactly what you would have expected in that type environment. And the portfolio wasn't hurt and even likely benefited if you also added term and stuck with the type bonds I recommend


Finally on the use of the word insurance, all you are doing is wasting time and effort by nitpicking over choice of words--personally I think using it is fine, especially since I explain what is meant by that, it's not like a one for one as you get with a short position. But it doesn't mean you don't get some protection, you cut tail risks, just like when you buy insurance. Sorry if you cannot see that.
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Re: How Commodities Can Help a Portfolio

Postby muntz » Mon Jun 03, 2013 6:26 pm

Bradley - I think a good definition of insurance is something with a Negative NPV that pays off when you need it. Sure- short selling stocks is one kind, but not the only kind. Commodities protect agst certain types of inflation risks that could harm the rest of your portfolio. In some cases, commodities zig when other stuff zags. This is central to the entire subject of Modern Portfolio Theory.
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Re: How Commodities Can Help a Portfolio

Postby Bradley » Tue Jun 04, 2013 9:56 am

muntz wrote: Commodities protect agst certain types of inflation risks that could harm the rest of your portfolio. ........... This is central to the entire subject of Modern Portfolio Theory.




Below are the thoughts of some of the brightest/most experienced minds in money management today which express their opinions on including commodities in a portfolio. Before learning the hard way, anyone thinking about adding commodities AND then adding term risk should first consider the following comments on commodities. I'm quite sure these men are very familiar with Modern Portfolio Theory.






Should not be in “anybody’s portfolio, at anytime, under any circumstances”
--------John Bogle




"You're picking up nickels in front of a steamroller"
----------William Bernstein





"Commodities for the long run? Not on your Nellie—I'd rather eat coal!!"
-----------Société Générale's star analyst Dylan Grice






“Any allocation that’s greater than zero is too much”
--------------------William Bernstein







“But commodities fail the expected real return test. That's why I don't include them in portfolios. The lower expected returns of commodity funds is not a fair trade for the proven real returns of assets such as stocks.
Low correlation is not, by itself, a good reason to do something. After all, stuffing money in a mattress has no correlation with stocks and bonds, but I don't recommend doing it.
-------------------Rick Ferri






“Commodities futures: Two things are wrong with this asset class. First, its future returns will likely be low - certainly much lower than they have been in the past; commodities are what I call an “asset class du jour,” on everyone’s financial lips. This is a real warning sign, since when everyone owns something, few buyers may be left to push up the price. Second, I just do not trust any of the commodities funds, or the companies offering them”
---------------------William Bernstein



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