Bogleheads

[660ky612]

Dear Forum,

There is a long and updated list about commodities in the library here http://www.diehards.org/forum/viewtopic.php?t=59
But we need an entry point perhaps.

o
Larry E. Swedroe, "The only guide to a winning investment strategy you'll ever need" New York, Truman Talley Books/St. Martin's Press, c2005. 1st rev. and updated ed. ----Appendix H: Commodities: A diversification and Hedging Tool

o In p.296 of the book, Swedroe mentioned: Paul D. Kaplan and Scott L. Kummer, "GSCI Collateralized Futures As a Hedging and Diversification Tool for Institutional Portfolios: An Update," Journal of Investing (Winter 1998)
A substitute goods is here http://corporate.morningstar.c....utures.pdf
It seems to me Kaplan and Kummer's 1998 work has not ever been mentioned in the forum.



From p.278 of swedroe's book: commodities ccf - the attractions are the low correlation to both bonds and stocks and the inflation hedge that neither stocks nor bonds offer. The greater the risk of inflation to the financial health of an investor, the more this asset class should be given consideration for inclusion in a portfolio.

Question: By sacrificing just a minor amount of expected return, the overall portfolio has a "much" lower S.D. Isn't that just portfolio theory? I want to be lazy and to have free lunch! Ladies and gentlemen!

Of course the problem is "Does commodities CCF work"? and how about REITs / non-US REITs and some safe Global Bonds?

Thanks, 660ky612 from Hong Kong

PS.
Has anybody read these articles before? Have you asked questions or participated in the discussions without consulting any necessary or essential documents?
Do you buy used books? http://www.abebooks.com/servle....=0&y=0

Have you just stated your assertions or opinions without stating the reason nor the source?

[stratton]

Another commodities info source is The Handbook of Inflation Hedging Investments. There are several chapters on commodities including how a commodities fund is run.

Paul

[larryswedroe]

Yes, that is what MPT is about, what Markowitz won the NObel Prize for--for showing that you can add risky assets with non perfect correlation and create more efficient portfolios. And the best assets to add in terms of improving efficiency are those with negative correlation as they act as portfolio insurance. And when you have negative correlation high volatility is actually good--at least when you add small amounts to the portfolio.

[LH]

Larry or whomever,

Can you give some idea of what percentage change a say 5 percent allocation(total) to CCF would do under the circumstances CCF is meant to be beneficial under?

With smaller allocations, say 5 percent, its always kinda bothered me that whatever effect it had, would be multiplied by 0.05 to get its effect on the total portfolio. Of course, if the expected return under adverse conditions is high enough relative to the expected downturn of other assets, then it would be worth it. I assume thats the case, thats its the RELATIVE return next to asset classes that have just taken a huge hit, and not relative to a baseline of zero return, thats the key.

Like if whole portfolio excepting CCF went down 30 percent, and the 5 percent CCF went up 30 percent, the comparision would be between:
0.95(-30)=28.5 loss
and
0.05(30)=1.5 percent upward movement whole portfolio

which comes out to 27 percent loss, instead of say a 30 percent loss total... That does not seem like a whole lot of help?

This whole thing is basically a question, I am unsure of all of it. But everytime I think of 5 percent of a portfolio, it doesnt seem like it would really effect things much.

Known errors I could be making here are:

1) the possible size of the swing, maybe its larger than I would think, maybe instead of going up 30percent, CCF would go up 100 percent.

2)ignoring the benefit of 27 vs 30 percent loss, maybe thats more significant than I think it is

3)my math or fundamental way of thinking about this is simply wrong : )

Thanks for help,

LH

[larryswedroe]

LH

Well in 73 when S&P fell 15% the GSCI was up 75%. So you can do the math. And in 2000 when the S&P fell 9% it went up 50%.

CCF is highly volatile and the negative correlation is a good thing.

Remember also that you not only get that return impact in one year the more important benefit is that it smooths the annual returns of the portfolio--the part of the issue Ferri repeatedly ignores in his analysis/critique, reducing the negative impact of volatility. This, as Bill Bernstein and I have both shown, can lead to the impact of CCF being as much as perhaps 5% more than the actual return if you viewed it in isolation.

Again, here is an example I gave based on GSCI and model portfolio
1970-2006. If you think it is not worth it, don't bother. To me this is a big deal.
Compound Return SD Worst Year
GSCI 11.51 18.81 -35.75
Portfolio A 15.86 14.99 -23.51
Portfolio B 15.96 14.25 -20.38

A is Value tilted type portfolio I recommend using DFA funds and B is with 5% GSCI

Thinking about it the way Rick Ferri does one would never consider CCF. Simple, low returns and high SD. And horrendous worst year. But note how small addition to the portfolio had the following three benefits
a) raised portfolio return
b) lowered SD
c)produced lower worst year than either alone

Note the diversification return. The GSCI was 3.45% lower return, yet portfolio return went up by 0.1%.

Now here to me is perhaps the most interesting for the Bogelheads to consider.

How much did the 95% equity contribute to the portfolio return of 15.96? 15.07% (95% x 15.86)

So how much did the CCF (the other 5%) contribute to generate the total portfolio return of 15.96%?

The other 5% must have added 89 basis points more to get to the total.

So it was if it had actually returned 17.8% or 89 bp x20 (on a weighted average basis).

So we might think of the diversification return benefit as 17.8- 11.5 or 6.3%. You think that should be ignored? Or was not worth it?

So if you thought that CCF would have a real return of say just riskless rate you still get the diversification return which should be considered.

[LH]

[larryswedroe]

LH
Say CCF returned 17.8% and is 5% of portfolio. Thus it contributed a total of 89bp to the portfolio.

Say the other 95% returned 15.86, so it contributed 15.07. The total portfolio return was 15.96.

So while the way Ferri would look at it he would say why buy this lousy asset with return of 11.51 percent and high SD. But the right way to look at it is if it returned 17.8% (the 11.5 plus the diversification return of 6.3)--the only right way to look at an asset is how it impacts the risk and return of the portfolio---that is what got Markowitz the Nobel Prize.

Now the really nice part is you got that effective return of 17.8% and you lowered the risk of the portfolio---Now you care to ignore it?

And this was only with 5%.

To me this is a very big deal, not trivial. And it shows that you only need a small allocation when you have negative correlation and high volatility.

[LH]

[larryswedroe]

LH
Your not looking at it right
The issue is you START with the 100% equity portfolio,Then you take away 5% equity and ADD 5% CCF.

Then you see what the impact was of adding the 5%.

You don't start with a 5% portfolio.

[LH]

[LH]

[market timer]

LH,

I think it makes sense to start as Larry does with a 100% equities portfolio, though you could take your own allocation as the initial point as well. Now, what Larry is doing is taking the derivative of total return with respect to CCFs, subject to the budget constraint (all investments sum to 100%). He finds that replacing equities with CCFs increases total return by the difference 17.8% - 15.8% at the margin. The marginal benefit of adding CCFs should be highest from a starting point of 100% equities, and gradually decreasing along the budget until you get to 100% CCFs. In theory, you should continue adding CCFs until the marginal benefit is zero -- that is when the "rebalancing bonus" shows CCFs are effectively yielding the equity return of 15.8% at the margin.

[LH]

[market timer]

The 2% difference (17.8% - 15.8%) is applied to only 5% of the portfolio, hence the 0.1% total increase in return (2% x 5%).

[larryswedroe]

Look this is simple

Of course the benefit comes from how the different asset classes interact--

But what we are looking for is the IMPACT of the addition of the asset class. In this case it is 6%, that is the diversification return--it is as if the asset class returned not 11.5 but much higher. And if you looked at only the return of the asset class and its SD then you make a HUGE mistake.

[660ky612]