Bogleheads

[DP]

Hi,
I am interested in feedback on two questions I have:

1. Anyone interested in explaining arguments against diversification with commodities? From my perspective, the arguments for are clear. Using data from the allocation spreadsheet http://www.diehards.org/forum/....preadsheet the returns are slightly higher than stocks: avg 13.18%/year, the volatility is only a little higher than stocks: 18.45% StdDev and the correlation is -.17! This is only a 36 year sample, but then in his book Hot Commodities, Jim Rogers referenced a study stating that from 1959 to 2004, commodities returns were comparable to the SP500. Combine this with the negative correlation and it seems to me a no-brainer. So why is it so often left out of example portfolio's?

2. Assuming commodities to be a suitable asset class to invest in, and knowing future returns are not predictable, and although there is no such thing as a perfect allocation, why shouldn't an allocation start with something like the 6 Ways from Sunday allocation: equal parts US Stocks, Int'l Stocks, Commodities, REITS, US Bonds, TIPS? (Scott Burns orginally used the Energy sector rather than commodities but I have seen an article by him suggesting commodities as a suitable alternative, subject to the investors preference). To me, such an allocation makes sense in theory (diversifies equally among high performing asset classes and uses bonds to reduce risk), it backtests extremely well, and could easily be adjusted to be as conservative/aggressive as desired. I rarely see references to such a diversified portfolio and given all the thought many people on this forum have put into their investments, I'm curious why not? Given a selection of high performing asset classes and no window into the future, I don't understand why some asset classes (US Stocks) are so often given a higher allocation than others (Int'l Stocks, Commodities, REITs).

Don

[bob90245]

I don't know if the returns for commodities you've seen have taken taxes into account. That asset class is not very tax-efficient. Therefore, I would guess that the returns you've seen for commodities may not compare so favorably on an after-tax basis.

Same thing goes for REITs. I adopted a portfolio similar to the Coffeehouse Portfolio which has 10% in REITs. It occupies the limited space I have for tax-deferred funds.

[larryswedroe]

CCF should only be held if have room in tax advantaged accounts IMO. So that limits its application for individuals, though not institutional investors

[Curtis Lowe]

[dave.d]

Don --

As a newbie, you missed the vigorous debates on commodities (actually CCF's) a couple of months ago between Larry Swedoe and Rick Ferri. Ferri argues against on the ground that they have zero expected real return (which is true). Larry got the better of that (IMHO) by observing how CCF returns are negatively correlated to stocks and bonds, thus very beneficial to an overall portfolio (or have been historically).

However, William Bernstein (also kind of a smart guy ) recommends against commodities on the ground that they're a little too "in" right now, and that CCF markets are now dominated by speculators trying to hedge against inflation, instead of producers trying to hedge against falling prices as used to be the case. I find that persuasive as a reason not to jump in with both feet right now. Bernstein's analysis is here:
http://www.efficientfrontier.c..../stuff.htm

CCF's are actually easy to own in a taxable account if you use iPath ETN's (ticker symbols DJP and GSP). However those involve both credit risk (Barclay's Bank) and some risk of an adverse tax ruling.

Your proposed 1/n portfolio including commodities and REITs is very similar to portfolios examined (and viewed favorably) by Roger Gibson in his Asset Allocation book, recently a new edition published.

[DP]

Hi,
Dave, thanks for the references. I missed these discussions in my earlier search. For others that missed them, a couple good discussions on this topic:

http://www.diehards.org/forum/....hlight=ccf
http://www.diehards.org/forum/....hlight=ccf
http://www.diehards.org/forum/....hlight=ccf

Reading these discussions raises another question. It is stated that Individual collaterized commodity futures (CCF) have an expected real return of 0%. The fact remains that the historical data (again from the backtest spreadsheet) shows Commodities CAGR from 1972 to 2007 is 11.72 and the CPI is 4.64 which seems like a very real return to me. To discount the recent bull market in commodities, I checked the average annual return from 1972 to 1998, 11.32 vs. 5.34. Still a very real return. Anyone have any thoughts why the actual returns differ so much from the theoretical?

(Edit) Posted this too soon, the Bernstein article in the prior post addresses this question and makes an interesting point.

Don

[docneil88]

[dumbmoney]

[larryswedroe]

ETNs
Nice for tax purposes but I would not buy them because you are taking two considerable and uncompensated risks
a) risk of tax treatment being disallowed, this is purely form over substance IMO
b) the credit risk of the issuer. Let's assume that the issuer pays say 0.5% over Treasuries for borrowings. You are taking that credit risk but not earning that extra return. Thus if an ETN costs you say 75bp it is really costing you 1.25%, only you just don't see the bill

[dave.d]

Larry, I find the risks of ETNs bearable in part because most accounts that I manage hold only about 1% each in GSP and DJP (plus another 1% in GLD). But you can post "I told you so" here if/when Barclay's goes up in smoke.

Risks would be considerably greater to use ETN's for CCF exposure in a 1/n-type portfolio as discussed above.

[tomser]

what is CCF

[DblDoc]

[tacitus7]

You may want to check out Roger Gibson's, Asset allocation: Balancing Financial Risk. I have the third edition, of which I understand there is now a fourth edition.

But on pages 250-256 of the third edition, there is a great set of charts of all the various ways to diversify, across all investment assets..... under "investment hedges" he includes the following: Commodity- linked securities, precious metal mining stocks, and precious metal bullion.

I think the author does an excellent job discussing the various pros and cons of these various options. At this site, there seems to be a lot of focus upon the value of commodity linked securities such as CCFs, but not so much favorable about the other two.

just some thoughts,
Joe E.

[larryswedroe]

dave
The main point is that you should consider the credit spread between libor and the ETN issuer's cost of long term debt as an incremental cost--even though you are not charged for it. You are taking that risk and not being compensated for it. Thus your returns are not appropriately being adjusted for the risks. Once you add in both the credit spread and the OER of the ETN (and consider that there is tax risk) IMO these are just not worth it. At some point the benefits of diversification with CCF are offset by higher costs. This seems to me to cross the line. Having said that you might be a very risk averse investor and value that insurance (negative correlation) that CCF provides more than average person and are thus willing to pay that extra cost.

Note I wonder how you would have felt if it was Bear Stearns that had issued that ETN and it had actually failed. Never treat the unlikely as impossible.

BTW--why not hold the PIMCO fund in a tax advantaged account instead?

[czeckers]

There is a Bear Stearns ETN following an index of Master Limited Partnerships (MLPs) introduced last summer that sounded interesting. At the time, the thought of Bear Stearns folding was unheard of. I was looking for non-correlated diversifiers for my portfolio and this seemed to fit the bill. I held off because I frankly don't understand ETNs or MLPs very well right now. Boy am I glad I didn't jump in.

This of course is purely anecdotal evidence against ETNs but the credit risk is there.
_________________
16% US LCB, 16% US SCV, 16% US REIT, 16% Developed Int'l, 16% EM, 10% Inter-term US Treasury, 10% TIPS

"A journey of a thousand miles must begin with a single step."

[plake15]

http://www.ccfr.org.cn/cicf200....044210.pdf

A good study/link done on TIPS,commodites,REITs..and how the diversifucation helps out portfolio.

[docneil88]

[stratton]

[dumbmoney]

[docneil88]

[dumbmoney]

[larryswedroe]

doc
good points, especially the one about no internal trading costs.

1) I think you probably underestimate the credit costs. Check for example what Lehman's long term bonds versus treasuries yield (I don't know). That would be the cost

2) Pimco uses swaps to access the index returns. The cost used to be about 40bp but now is way below that, I think if my memory serves me now like about 8. So nowhere near enough to offset the credit costs.

And I do think there is tax risk.

Finally, at least so far PIMCo has actually added value in terms of managing the roll return. Last year like 30bp if memory serves and this year they are estimating perhaps 60, but time will tell. Certainly take on some tracking error.

[nisiprius]

The appeal to authority: based on what I read, experts don't think commodities are such safe and powerful diversifiers than an ordinary naïve investor like myself does himself harm by just ignoring them.

1) Tobias: