the problem is that commodities, as measured by the Reuters-CRB, for the period 1991-2004, returned less than T-Bills. I can't eat low correlation. Commodity prices are volatile, and if an investment in the asset classs is expected to achieve T-bill rates of return, wouldn't you be better off skipping the asset class (Commodities or whatever) and putting your money in something that rewards you for the risk?
The answer combines philosophy and faith. For me the philosophy is that by allocating to disparate asset classes I'll own the one that has a great year and there is less need to predict which one will be the one to have a great year. So if domestic stocks have a bad year it might be possible to bring up the overall return by getting a lot out of commodities or emerging market bonds or infrastructure or whatever. This has worked in the past and the faith part of the equation is that it will work in the future without having to rely too much on things "going right."
If you have eight different asset classes one of them will be the best performer, that best one may or may not be up a lot but often it is.
The example I used in my reply in the comments was market up 10% a diversified portfolio with 50 stocks being up 9-11% with one stock originally weighted at 2% being up 100% is very plausible. That one stock would account for a disproportionate amount of the total return.
It is is often the case that a disproportionate amount of a portfolio's return will come from just a few things. How is your portfolio YTD? Got any emerging market exposure? What is the weighting of that exposure and how much of your return came from that exposure? Do you have any energy stocks or an energy ETF? The energy sector SPDR is up 25% YTD. An equal weight to energy might be a big chunk of your return too. The Gold ETF (GLD), which is a client holding, is hardly an obscure holding is up 25% also. A 3% allocation from the beginning of the year would have added 75 basis points YTD which in an environment of SPX up 3.4% (plus dividend) seems like a lot.
The dilemma raised in Jimidean's question about commodities having trailed the return of t-bills during the period cited raises two points. One is that obviously that is in the past. The numbers might be a little different if he had picked a different 14 year period and more importantly looking forward are commodities likely to lag t-bills again?
The other point is that if he is worried that commodities will lag t-bills he should underweight the sector. If he is right, great but if he is wrong his portfolio can still get some benefit from an underweight exposure if commodities rocket higher. That is to say the consequence of being wrong could be lessened.
The view expressed in this post is just one of many valid ways to construct a portfolio and manage diversification. No one path can be the best path for all markets. My idea will work well some portion of the time as will more aggressive or more conservative approaches at other times.
9 comments:
On 10.04.2007, Mebane Faber posted about managed futures on World Beta("The Next Generation of Commodity Indexes" - http://worldbeta.blogspot.com/2007/10/taking-it-back-to-80s.html)
Historical data from Morningstar seems to indicate a Long/Flat commodity strategy could yield 10.74% per year based on 1980-2006 data.
This maybe a better way of diversifying a portfolio with commodities when an ETF is made available with strategy.
CA
I amazes me that there are still some investors that argue against broad diversification based on looking back at some single sector that underperformed in the past.
I suppose that this also means that financials will never again be a logical investment choice.
hi, i wasn't arguing against broad diversification, just trying to think thru the proper weighting to the various asset classes I have included in my portfolio. Looking at historical returns seems like a logical first step. Thanks for your inputs Roger, I have learned alot from reading and listening to you.
jacks: I believe William O'Neil argues against broad diversification.
Roger,
I tend to agree with JimiDean. Pin up 100-year charts of your favorite equity and commodity indices - better yet, use inflation adjusted charts. A long term equity chart will look quite different from any commodity.
Commodities are not like equities. A long term buy and hold investor can be pretty confident of beating T-Bills and inflation over almost any 20 year period. A commodity investor can't.
Commodities are a great add to a portfolio BUT they require market timing, equities don't.
Larry, Warren Buffett has no use for broad diversification either.
Sam
When you say Commodities I am not sure what type of product you are talking about here. I can tell you that I use a commodity fund for clients by Credit Suisse and also use managed futures. My issue with these has been that you are getting some type of exposure to commodities but contango and backwardation seem to dictate the returns as much or sometimes more than the underlying commodity.
It's been frustrating watching the commodity go up but the forward future contracts dropping.
I've owned GLD for a long time and am considering one of the food products.
contango is more of an issue with oil. I have stayed away from oil becuase of that and what I perceive as a lot of volatility.
Sam.
As soon as you become as smart as Warren Buffet you too can avoid broad diversification. In the meantime....
Even Jim Cramer knows that diversification is the only free lunch.
But one can underweigh and overweigh sectors as the markets indicate. Just don't avoid them altogether. I believe that this is the general theme of Roger's blog here.
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