A Sec­tor to Watch

In­clud­ing com­modi­ties funds in a port­fo­lio may help clients as in­fla­tion ticks up.

Financial Planning - - CONTENTS - BY CRAIG L. IS­RAELSEN

In­clud­ing com­modi­ties funds in a port­fo­lio may help clients as in­fla­tion ticks up.

Clients who own a com­modi­ties fund must be able to roll with the leaner times, when re­turns are neg­a­tive.

The U.S. econ­omy has been in a low-in­fla­tion en­vi­ron­ment for the past decade. But in a twist on the old cliché: When it comes to in­fla­tion, what goes down must come up. The av­er­age an­nu­al­ized rate of in­fla­tion as mea­sured by the Con­sumer Price In­dex has been 1.61% since 2008, com­pared with 3.99% since 1970. If cy­cles re­peat, in­fla­tion will rise again. When it does, com­modi­ties will be the likely win­ner, as demon­strated in the chart “Low and High In­fla­tion.” Over the past 48 years (1970-2017), com­modi­ties had an av­er­age an­nual gross loss of 1.97% (-4.03% av­er­age real re­turn) dur­ing the 24 years with below me­dian in­fla­tion. By con­trast, in the 24 years with above me­dian in­fla­tion, com­modi­ties had an av­er­age an­nual gross re­turn of 21.98% and an av­er­age an­nual real re­turn of 15.13%. The per­for­mance of com­modi­ties here is based on the S&P Gold­man Sachs Com­mod­ity In­dex (GSCI). The 48-year his­tor­i­cal per­for­mance of large-cap U.S. eq­ui­ties in the chart is rep­re­sented by the S&P 500, while the per­for­mance of small-cap U.S. eq­ui­ties was cap­tured by us­ing the Ib­bot­son Small Com­pa­nies In­dex from 1970 to 1978, and the Rus­sell 2000 from 1979 to 2017. The per­for­mance of non-u.s. eq­ui­ties was rep­re­sented by the Mor­gan Stan­ley Cap­i­tal In­ter­na­tional EAFE In­dex. U.S. bonds were rep­re­sented by the Ib­bot­son In­ter­me­di­ate Term Bond In­dex from 1970 to 1975 and the Bar­clays Cap­i­tal Ag­gre­gate Bond In­dex from 1976 to 2017. Cash was rep­re­sented by three-month Trea­sury bills. The per­for­mance of real es­tate was mea­sured by us­ing the an­nual re­turns of the NAREIT In­dex from 1970 to 1977. From 1978 to 2017, we used the an­nual re­turns of the Dow Jones U.S. Se­lect REIT In­dex. If clients own a com­modi­ties fund as part of a broadly di­ver­si­fied port­fo­lio, they must be able to roll with the leaner times. From 2009 to 2017, com­modi­ties pro­duced an an­nu­al­ized gross re­turn of mi­nus 4.84% (based on the S&P Gold­man Sachs Com­mod­ity In­dex). That’s a pretty rough go. But over the past 48 years, the GSCI pro­duced an an­nu­al­ized gross re­turn of 6.99% (2.88% real re­turn). It can cer­tainly be feast or

famine with com­modi­ties. But when in­fla­tion heats up, com­modi­ties ben­e­fit be­cause ris­ing com­mod­ity prices are of­ten the very cause of in­fla­tion. While the GSCI is an im­por­tant com­mod­ity in­dex, there are other broad-bas­ket com­mod­ity in­dexes wor­thy of con­sid­er­a­tion, which can be seen in the chart “Big Four.” I’m fo­cus­ing on these par­tic­u­lar in­dexes be­cause of their promi­nence as well as the dif­fer­ences in their method­olo­gies. The choice of in­dex mat­ters be­cause the com­po­si­tion of the in­dex in­flu­ences the allocation that com­mod­ity mu­tual funds and ex­change­traded prod­ucts mimic. For ex­am­ple, the Thom­son Reuters Equal Weight Con­tin­u­ous Com­mod­ity To­tal Re­turn In­dex has a much lower allocation to en­ergy than the Deutsche Bank Liq­uid Com­mod­ity Op­ti­mum Yield Di­ver­si­fied Com­mod­ity In­dex Ex­cess Re­turn (17.6% ver­sus 59.4%). The S&P Gold­man Sachs Com­mod­ity In­dex has an even higher allocation to en­ergy, at 65.4% (as of May 2018). Thus, the funds that track each of the dif­fer­ent in­dexes will have markedly dif­fer­ent al­lo­ca­tions to en­ergy. The four com­mod­ity funds we use are the Wis­domtree Con­tin­u­ous Com­mod­ity In­dex Fund (GCC), the ipath Bloomberg Com­mod­ity In­dex To­tal Re­turn (DJP), the In­vesco DB Com­mod­ity In­dex Track­ing Fund (DBC) and the ishares S&P GSCI Com­mod­ity-in­dexed Trust (GSG). DJP is an ex­change-traded note; the other three are ETFS. In 2014 and 2015, DBC and GSG had large losses due to their higher al­lo­ca­tions to en­ergy. By con­trast, GCC and DJP had rel­a­tively bet­ter per­for­mance based on their smaller en­ergy al­lo­ca­tions.

Rid­ing Out the Rough Times

Suf­fice it to say, 2014 and 2015 were very rough years for oil. The largest com­modi­ties fund ded­i­cated to the en­ergy sec­tor is United States Oil Fund (USO). In 2014, USO had a gross re­turn of mi­nus 42.36%, fol­lowed by a loss of 45.97% in 2015. As oil prices re­bound, how­ever, DBC and GSG may per­form bet­ter than other broad-bas­ket com­modi­ties funds with a smaller allocation to en­ergy.

Al­lo­ca­tions to the var­i­ous com­mod­ity sec­tors dif­fer sub­stan­tially among the in­dexes.

Con­sider also the dif­fer­ent al­lo­ca­tions to agri­cul­ture. The in­dex that GCC tracks has a 47.1% allocation, whereas the in­dex that GSG tracks has a 14.6% allocation. Big dif­fer­ence. The allocation to pre­cious met­als also dif­fers widely, with GCC and DJP both over 15%, while GSG is below 4%. The point is that the al­lo­ca­tions to the var­i­ous com­mod­ity sec­tors dif­fer sub­stan­tially among the in­dexes (and the funds that track them), and this af­fects per­for­mance from year to year. For ex­am­ple, in 2010 GCC had a re­turn of 25.4%, whereas GSG had a re­turn of 7.83%. In 2016 DBC was up 18.5%, whereas GCC posted a gain of only 4.27%. (All re­turns are gross.) Of course, very few in­vestors have a port­fo­lio that con­tains only a com­modi­ties fund. Thus, the more rel­e­vant is­sue is how well a com­modi­ties fund con­trib­utes to over­all port­fo­lio per­for­mance. We can test this by in­sert­ing each of our four com­modi­ties funds into a di­ver­si­fied port­fo­lio and mea­sur­ing over­all per­for­mance over the past nine years. If GCC was used as the com­modi­ties fund in a 12-as­set-class port­fo­lio (with an 8.33% allocation each to large-cap U.S. stocks, mid­cap U.S. stocks, small-cap U.S. stocks, non-u.s. stocks, emerg­ing stocks, real es­tate, nat­u­ral re­sources, com­modi­ties, U.S.

bonds, U.S. TIPS, non-u.s. bonds and cash), the av­er­age an­nu­al­ized gross re­turn was 8.59%. This is as­sum­ing an­nual re­bal­anc­ing at the end of each year. If DJP was used as the com­modi­ties fund, the nine-year an­nu­al­ized gross re­turn was 8.38%. With GSG, the gross re­turn was 8.29%. And if DBC was used, the nine-year gross re­turn was 8.52%. Clearly, which com­modi­ties fund you ad­vise a client to in­vest in mat­ters on a year-to-year ba­sis if their only port­fo­lio hold­ing is a com­modi­ties fund. But in a broadly di­ver­si­fied port­fo­lio, it mat­ters less which com­modi­ties fund you se­lect, as shown by the sim­i­lar­ity in the over­all port­fo­lio. This re­moves the pres­sure to pick the right fund. The key is to have ex­po­sure to a broad-bas­ket com­modi­ties fund that will pro­vide up­side per­for­mance po­ten­tial when we ex­pe­ri­ence our next round of in­fla­tion. And we will.

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