Commodities

Updated June, 2006

Commodities investing is getting to be like English weather. If you don't like what's on offer today, just wait a bit, and it will change. This past month has seen the introduction of two new commodity indexes. The Lehman Brothers Commodity Index contains twenty commodities and annually resets their weights based on their futures trading volume. These weights then adjust during the year based on price changes. The current weight of energy commodities is about 53%, with metals at 27% and agricultural products at 20%. The Merrill Lynch Commodities Index contains eighteen commodities. They are initially selected based on their futures market liquidity, and then weighted by their importance in the global economy. Their current weights are energy, 60%, Metals, 17%, and agriculturals, 23%.

The following table shows how these weightings compare with other commodity indexes (GSCI = Goldman Sachs Commodities Index; DBLCI = Deutsche Bank Liquid Commodities Index; RICI = Rogers International Commodities Index; DJAIG = Dow Jones AIG Commodities Index):

	GSCI	MLCX	DBLCI	LBCI	RICI	DJAIG
Energy	74%	60%	55%	53%	44%	33%
Metals	12%	17%	23%	27%	21%	26%
Agric.	14%	23%	22%	20%	35%	41%
High-Low Weight	62%	43%	33%	33%	23%	15%

When it comes to weighting, we will reiterate a comment we've made before: the most reliable source of commodity index returns over time is the "diversification yield." This is the benefit that results from holding a portfolio of commodities whose returns have low correlations with each other (see, for example, "The Tactical and Strategic Value of Commodity Futures" by Erb and Harvey). However, as Kat and Oomen note in a new paper ("What Every Investor Should Know About Commodities"), the correlations between the returns on different commodity groups (i.e., energy, metals, and agriculturals) are much lower than between the returns on commodities within each of them. Hence, the diversification yield should be maximized (and volatility minimized) when different commodity groups are held in roughly equal proportions. Hence our continued preference for the Dow Jones AIG Commodities Index. As you can see in the table above (specifically, the high minus low weight row), it is the most balanced of all the commodity indexes available today.

However, there is more to the new index products than simply their weighting schemes. Like the Deutsche Bank Liquid Commodities Index, the Merrill index also will employ a flexible approach to "rolling" its contracts. This refers to selling maturing contracts (to avoid having to deliver the physical commodities) and reinvesting the proceeds in longer - dated ones. When futures prices are lower than spot prices (known as "backwardation") this produces a positive "roll yield" which in theory is an insurance premium provided by sellers of physical commodities to buyers of futures contracts. When futures prices are higher than spot prices (known as "contango"), the roll yield is negative. There is disagreement about what causes this. One explanation is an excess of futures buyers relative to physical sellers. Another is based on heightened supply and delivery risks in the physicals market. Whatever the cause, contangoed commodity prices reduce the profitability of investing in long-only commodity index products. For this reason, providers of those products are now experimenting with different approaches to reducing negative roll yields during periods when prices are contangoed. In the case of the Merrill Lynch product, this involves selling contracts further away from their maturity date, and reinvesting in even longer-dated futures, on the theory that the degree of contango (and thus the size of the negative roll yield) will be lower.

This past month also saw the launch of two interesting new commodities products. The first was by ABN AMRO and Lyxor in Germany, where a new ETF will track the Rogers International Commodities Index. The second was in the United States, where Barclays launched two new structured notes whose returns are linked to the GSCI and DJAIG. Called "iPath Exchange Traded Notes" (ETNs) they are AA rated debt securities issued by Barclays Bank PLC that are listed on the New York Stock Exchange. Upon either their redemption or maturity in 2036, they will pay a return equal to the principal amount times the cumulative return on the relevant commodities index less a cumulative expense charge of .75% per year. They carry no sales load, but you will have to pay a brokerage commission to buy them. Besides their low annual expense charge, the most attractive feature of the iPath ETN product is its tax treatment: since the only payment to an investor occurs when the note is redeemed or matured, taxes are deferred and, according the prospectus, any profits earned should be taxed as capital gains. For taxable investors, these ETNs represent a significant improvement over both exchange traded funds and mutual funds commodity index products. However, this tax treatment is not certain. As as the iPath website notes, "Absent an administrative or judicial ruling to the contrary, iPath ETN securities should be treated for all tax purposes as pre-paid contracts with respect to the relevant index. If the iPath ETNs are so treated, investors will recognize capital gain or loss upon the sale, redemption or maturity of their iPath ETNs in an amount equal to the difference between the amount they receive at such time and their tax basis in the securities. The United States Federal income tax consequences of an investment in the iPath ETNs are uncertain. It is therefore possible that the Internal Revenue Service may assert an alternative treatment. Because of this uncertainty, investors are urged to consult their tax advisor as to the tax consequences of an investment in the iPath ETNs." Given the way the IRS treated PIMCO, an adverse federal tax ruling is certainly something to worry about. We'd be a lot more enthusiastic if the tax treatment were clearer at this point. One other unknown is the extent to which liquid secondary market for these ETNs will develop. This is crucial for people who want to buy and sell them before maturity, for example as part of a rebalancing program. At this point, it is too early to tell if this will be the case. Still, assuming the tax issue is favorably resolved and a secondary market develops, this is an excellent product structure.

On the commodities research front, we also read some interesting reports over the past month. In "Commodity Prices and Monetary Policy", Professor Jeffrey Frankel from Harvard argues that low real interest rates lead to high commodity spot (physical) prices, and vice versa. With the world's central banks now tightening policy, and real rates rising, the implications are clear. Franke's research is supported by findings in a Bank of Canda working paper ("Forecasting Commodity Prices: GARCH, Jumps, and Mean Reversion" by Bernard, Khalaf, Kichian and McMahon) that finds that commodity spot prices tend to mean-revert over time. Closely related to this is a paper by Craig Pirrong, "Momentum in Futures Markets." He finds that momentum in futures markets has a correlation of .26 to .30 with momentum in equities markets, and that it typically reverses after about one year. In another paper, "Momentum in Commodity Futures Markets", Miffre and Rallis find that momentum strategies that buy futures contracts on backwardated, high volatility commodities and sell futures contracts on contangoed high volatility commodities with high volatilities have historically earned attractive returns that have a low correlation with those on other asset classes. This is quite similar to the strategy tracked by the MLM Index, produced by Mount Lucas Management. In some countries (e.g., Canada), products are available that track this index. However, as we noted in our April 2006 issue the MLM's returns have a low correlation with those on long-only commodity indexes like the GSCI or DJAIG; in truth it is more of a hedge-fund type product.

Updated April, 2006

New Lyxor ETF Tracking the Reuters Jeffries CRB Commodities Index

Our Eurozone readers now have another commodity index ETF in which they can invest, besides the EasyEFT product that tracks the Goldman Sachs Commodities Index. Lyxor recently introduced a new product that tracks the Reuters Jeffries Commodity Research Bureau Index. The original CRB Index has been around for a long time, and gone through many changes of weighting schemes. The current index was introduced in 2005, with backwards calculations to 1995. Its weightings are very similar to those used by the Dow Jones AIG Commodity Index. They both give a 41% weighting to agricultural commodities; however, the DJAIG gives more weight to metals (26% vs. 20% for the RJCRB), while the RJCRB gives a higher weight to energy commodities (39% vs. 33% for the DJAIG). The historical data that accompanied the launch of the RJCRB index in 2005 showed that its historical standard deviation was about equal to that of the DJAIG, and its correlations with other commodity indexes and asset classes were also similar.

Of course, it goes without saying that the launch literature also used a comparison period during which the RJCRB slightly outperformed the DJAIG; however, by shifting the dates you can no doubt get the opposite result. That is why we focus on volatility (standard deviation) and correlations in our commodity index comparisons. In this case, the RJCRB and DJAIG appear to be quite close substitutes, with substantially lower weighting on energy than the 73% found in the Goldman Sachs Commodities Index. As we have noted in the past, since a substantial part of the expected return from a commodity index comes from the "diversification effect" (i.e., the benefit of investing in a group of different commodities whose returns have low correlations with each other), we prefer indexes that are relatively balanced across energy, metals, and agricultural commodities, as this will tend to maximize the diversification benefit. For this reason, we prefer indexes like the DJAIG and RJCRB.

However, we should also note that the new Lyxor ETF that tracks the RJCRB Index is somewhat different from other commodity index products. As we have noted in the past, commodity index funds invest in a mix of futures contracts, either directly or via swap contracts. In both cases, these investments are initially made at less than their full face value (e.g., to purchase a futures contract worth 100, you might only have to put down 10). Other commodity index funds usually invest the balance of their assets in government bonds. However, it appears from the Lyxor offering document (which is notably unclear on this point) that this fund will invest the balance of its assets in equities rather than bonds. Whether this will materially increase the riskiness of this product compared to other commodity ETFs ultimately depends on the nature of the derivative contracts (e.g., swaps) used by the fund. Unfortunately, the fund's offering document sheds little light on this issue, beyond saying that its objective is a tracking error versus the RJCRB index of no more than 1% per year. Finally, we should also note that the Lyxor Commodities ETF has a very attractive .35% expense ratio, which is much lower than the charges on similar funds in the United States, and below the already very low .45% charge on the EasyETF that tracks the GSCI.

Last but not least, we will also point out that there is an exchange rate risk lurking in both the Lxyor and EasyETF commodities products. This is due to the fact that the commodity indexes they track are quoted in U.S. dollars. Hence, a sharp depreciation of the USD versus the Euro could substantially reduce the return on these funds, even if commodity markets remain strong. Were commodity markets to weaken at the same time as the USD declined against the Euro, the fall in returns would be even more severe. This makes the point that, in cases where an asset class appears to be substantially overvalued (and we have made that case for both commodities and the U.S. dollar), prudent risk management will sometimes require an investor to reduce his or her allocation to an asset class to a level below its long-term (normal) policy weight in his or her portfolio.

With the launch and rapid price increase in gold-backed exchange traded funds, many investors are wondering if these products belong in their portfolios.  There are some important points to keep in mind when making this decision.  First, well-diversified commodity indexes already include an allocation to gold futures (e.g., 6.22% in the Dow Jones AIG Commodity Index, and 2.10% of the Goldman Sachs Commodities Index). The question, therefore, is whether to increase these relative weights by investing in a gold ETF.  We continue to believe that the medium term case for making an additional allocation to gold is fundamentally based on one's perception of the relative importance of its role as a store of value during periods of great monetary instability, including both deflation and inflation.  Since current global economic conditions have increased the probability that one, and perhaps both of these conditions will occur in the future (e.g., a sharp economic slowdown that triggers deflation, followed by a concerted attempt to reflate the global economy), the case for holding gold has undoubtedly strengthened.  That being said, we have found no way to relate the strength of that case to the fairness of the current gold price, which appears to be drive as much by momentum as by fundamental valuation logic. Moreover, if one assumes that periods of great monetary instability may also put the functioning of financial markets at risk, then we continue to argue that holding a small amount of physical gold (e.g., coins in a safe deposit box) makes more sense than an ETF backed by gold bullion. Nevertheless, we recognize that many people might prefer the latter because it is a less complicated approach.

More on Gold (ETF vs Physical)

With the launch and rapid price increase in gold-backed exchange traded funds, many investors are wondering if these products belong in their portfolios. There are some important points to keep in mind when making this decision.

First, well-diversified commodity indexes already include an allocation to gold futures (e.g., 6.22% in the Dow Jones AIG Commodity Index, and 2.10% of the Goldman Sachs Commodities Index). The question, therefore, is whether to increase these relative weights by investing in a gold ETF.

We continue to believe that the medium term case for making an additional allocation to gold is fundamentally based on one's perception of the relative importance of its role as a store of value during periods of great monetary instability, including both deflation and inflation. Since current global economic conditions have increased the probability that one, and perhaps both of these conditions will occur in the future (e.g., a sharp economic slowdown that triggers deflation, followed by a concerted attempt to reflate the global economy), the case for holding gold has undoubtedly strengthened.

That being said, we have found no way to relate the strength of that case to the fairness of the current gold price, which appears to be drive as much by momentum as by fundamental valuation logic. Moreover, if one assumes that periods of great monetary instability may also put the functioning of financial markets at risk, then we continue to argue that holding a small amount of physical gold (e.g., coins in a safe deposit box) makes more sense than an ETF backed by gold bullion. Nevertheless, we recognize that many people might prefer the latter because it is a less complicated approach.

Updated March 2006

Rogers International Commodity Index TRAKRS

In November, 2005 Merrill Lynch launched new TRAKRS (Total Return Asset Contracts) futures contracts linked to the performance of the Rogers International Commodities Index (RICI). TRAKRS differ from other futures contracts in that they are not leveraged (you must put down their full value when buying them) and (in the United States) they may be held in a regular brokerage account rather than a special futures account. These latest TRAKRS mature on October 26, 2010. At that date, the value of the TRAKR will equal the accumulated value of the Rogers Index, less a 1.95% per year fee (similar to an expense charge on a mutual fund or ETF). If it is held in a taxable, account, any capital gains taxes will be due when the TRAKR matures. If an investor wished to maintain his or her investment in the commodities asset class, he or she will then have to either roll the after-tax proceeds into another commodities TRAKR (if one has been issued by Merrill Lynch), or another commodities ETF or mutual fund product.

So, how does this new product compare with existing commodity index products? Let's start with the underlying indices. The following table shows the weights of major commodity groups in four different commodities indices.

	Goldman Sachs Commodities Index (GSCI)	Deutsche Bank Liquid Commodities Index (DBLCI)	Rogers International Commodities Index (RICI)	Dow Jones AIG Commodities Index (DJAIG)
Energy	73.0%	55.0%	44.0%	33.0%
Agricultural	16.0%	22.5%	35.0%	41.0%
Metals	11.0%	22.5%	21.0%	26.0%
Total	100.0%	100.0%	100.0%	100.0%

The next table shows the annual expense charges on index products that track these four commodity indices:

	Goldman Sachs Commodities Index (GSCI)	Deutsche Bank Liquid Commodities Index (DBLCI)	Rogers International Commodities Index (RICI)	Dow Jones AIG Commodities Index (DJAIG)
Product (Ticker)	Oppenheimer Real Assets Fund QRAAX (Mutual Fund)	Deutsche Bank Commodities  Fund DBC (ETF)	RCI TRAKR (Chicago Mercantile Exchange Futures Contract)	Pimco Commodities Real Return Fund PCRDX (Mutual Fund)
Expenses	1.32%	1.30% (as of 2Mar06 8K Filing)	1.95%	1.25%

In terms of long-term return correlations, the four indexes are quite similar to each other, as shown in the following table. However, as you can also see, the RICI and DJAIG, with their lower energy weightings, were considerably less volatile than the GSCI and DBLCI.

1994-2004 Return Correlations and Standard Deviation of Nominal Returns

We have not included average returns for the simple reason that, depending on the period chosen, it is easy to show any of the four indices outperforming the others.

We wrote about the new U.S. ETF that tracks the DBLCI in our January 2006 issue. To make a long article short, we found no compelling reason to prefer it to our first choice, PCRDX. When it comes to the RICI versus DJAIG index comparison, both are preferable in our mind to either GSCI or DBLCI. Both RICI and DJAIG offer a more balanced exposure to different commodities, while GSCI and DBLIC have quite heavy energy weightings. This is important, because the diversification return is an important source of the total return on a commodities index (see our February 2006 issue, or below, for more on this). However, the RICI TRAKR carries a heavier expense load and will, if held in a taxable account, be subject to capital gains taxes when it matures in 2010. For this reason, we continue to prefer PCRDX as our vehicle for implementing an allocation to the commodities asset class.

What is the MLM Commodity Index?

The MLM Index was launched in 1988 by Mount Lucas Management of Princeton, New Jersey. It is based on a quantitative trend following (momentum) strategy, applied to an equally weighted mix of energy, metals, agricultural, interest rate and currency futures contracts. Mount Lucas Management revises the number of contracts traded each year; the companies last 10-K report (filed with the U.S. Securities and Exchange Commission) showed that it was using 22 different contracts. The trend following strategy causes the index to take both long and short positions in these futures contracts. In this sense, the MLM Index is not a true "passive strategy"; it very clearly has an underlying active component. Rather, we prefer to view it as one of a number of benchmarks against which the performance of other "Commodity Trading Advisors" (essentially, firms that actively trade futures contracts) can be measured. From a different perspective, the dynamics of the MLM Index are very different from those of long-only passive commodities indices like the Goldman Sachs Commodities Index or the Dow Jones AIG Commodities Index. For example, in 2005, both of the latter delivered higher returns than the 3.75% (in US Dollars) on the MLM Index. Like many commodity trading advisors, the MLM Index suffered from the lack of strong trends in many commodities futures market. However, that being said, over a longer period the MLM's performance looks better, in particular because of its lower volatility compared to the GSCI and DJAIG. However, its low correlation versus both of these indices also shows it is a very different product -- a active trading strategy (like a hedge fund) rather than an asset class.

In Canada, SEI Investments offers a product (the SEI Futures Index Fund) that tracks the MLM Index. Unfortunately, there are, as yet, no products available in Canada that track the GSCI or DJAIG.

Updated February 2006

At the end of 2003, there was approximately $500 million invested in commodity index products of all types (e.g., mutual funds, structured notes, etc.) The most recent estimate we saw now places this figure at $13 billion. We have also seen, at least over the past few years, commodity index funds deliver attractive returns. This raises an inevitable question: are commodity index funds overvalued today?

We'll begin our analysis with a brief overview of the return generating process for a commodity index fund. We know this gets a bit technical; however, please bear with us as it is necessary to understand our valuation analysis. This return generating process has five main elements. The first is changes in foreign exchange rates. Since most commodities are priced in U.S. dollars, investors with other functional currencies will derive a portion of their returns from exchange rate changes.

The second source of return is known as the “collateral yield.” To see how this works, let's assume an investor buys a share of a commodity index fund for $100. The commodity index fund then uses part of this $100 to purchase futures contracts (we'll leave swaps and other approaches the fund might use to invest in commodities out of this discussion). A future contract obligates the owner to purchase a fixed amount of a commodity at a specific date in the future at a specific price. These contracts do not require that the buyer immediately pay the full value of the contract. Rather, the buyer initially provides only a fraction of the value of the contract, which is known as the “margin” amount. The remainder of the $100 received from the investor is invested in another investment, typically government bonds. The return on these bonds is known as the “collateral return.”

The third source of return for a commodity index fund is the diversification benefit from investing in a number of commodities whose returns (a) have high volatilities, and (b) low correlations with each other. In their paper “The Tactical and Strategic Value of Commodity Futures”, Erb and Harvey estimate the size of this “diversification return” at 3.0 to 4.5% per year for a fund holding a range of different commodity futures contracts.

The fourth source of return for a commodity index fund is unexpected changes in the cash market (also known as the “spot market”) value of the commodities on which it owns futures contracts. For example, let's say a commodity fund purchased a futures contract today that obliged it to buy 1,000 barrels of oil in three months at $60 per barrel. Implicit in that $60 futures price is investors' collective forecast of the future spot price of oil (however, because of the factors described below, it is not accurate to say that $60 itself is the forecasted future price). Since the commodity fund is not in the business of taking delivery of physical oil (and incurring storage charges), it will sell this futures contract close to its maturity date (technically, settlement date), and use the proceeds (technically, “roll over” the proceeds) to purchase another three-month oil futures contract. As the settlement date nears, the market value of the futures contract will converge with the spot price of oil (i.e., the price at which you can purchase physical oil for immediate delivery). Assume that the spot price actually rises to $70 per barrel. The “spot return” on this futures contract will be $10 per barrel, which represents the unexpected change in the spot market price.

The fifth source of return for a commodity index fund is known as the “roll return.” It reflects the observation that, even absent any expected change in the spot price over time, the futures contract price for a commodity will still not equal the spot price. A situation in which the futures price is lower than the spot price is known as “backwardation.” A situation in which the futures price is higher than the spot price is known as “contango.” As previously noted, commodity index funds are buyers, not sellers of commodity futures contracts. As such, they prefer backwardation, which allows them to buy low, and sell high, so to speak, and earn a positive “roll return.” In contrast, if they are facing a contango, their roll return will be negative - the commodity index fund will be forced to buy high and sell low.

Apart from being rather intimidating words, the subject of whether one should normally expect commodity prices to be backwardated or contangoed is one of the most contentious subjects in finance. Broadly speaking, there are two schools of thought.

The first is known as the “hedging pressure” or “insurance” theory of commodity futures prices. The classic article on this theory is “Hedging Pressure Effects in Futures Markets” by de Roon, Nijman and Veld. In essence, it assumes the existence of one party that wants to limit its exposure to changes in commodity prices, and another who will provide this insurance for a premium, which takes the form of a difference between the spot price and the futures price. One example of this would be a commodity producer that wanted to lock in a future commodity price (e.g., because it must pay a fixed interest rate on its debt). It sells a futures contract that commits it to sell a specified amount of the commodity at a specified price at a specified date in the future. The buyer of that futures contract cannot be certain of the future spot price (though he or she will undoubtedly have made a forecast of what it will be). In exchange for taking on this risk, the buyer requires a futures price that is below what he or she expects the spot price to be.

Now consider another alternative. In this case, it is a producer of a product that uses large amounts of a commodity as an input. If the producer cannot pass on (in the form of higher prices) changes in the cost of the commodity, it will want to lock-in the price of that commodity. It can do this by buying a futures contract that obliges it to purchase a specified amount of the commodity at a specified price at specified date in the future. In this case, the party providing the insurance will be the seller of the futures contract. The insurance premium charged will take the form of a futures price that is higher than the expected spot price.

These two examples make another point clear: the hedging pressure (or insurance) theory of commodity futures prices is agnostic about whether backwardation or contango is the normal state of affairs. As you can see, both make logical sense, depending on the circumstances. On balance, backwardation is probably more likely only because in the case of most commodities there are more producers who are worried about price risk than consumers who are worried about cost risk.

So how well does the evidence align with the hedging pressure theory? The best answer is, “reasonably well, but with some important exceptions.” On the positive side, some commodities seem to be backwardated and contangoed fairly consistently. On the negative side, there are other commodities that seem to vary between the two. This has led to the search for second theory to explain commodity futures pricing.

This second theory is variously known as the theory of storage or of “convenience yield.” Its starting assumption is that the alternative to buying a futures contract is to buy the commodity immediately at the spot price, and then pay storage and financing charges until it is used. The futures contract price should therefore be equal to the spot price plus storage and financing costs - in other words, contango should be the normal state of affairs. But as we know, sometimes it is not. The reason for this is buyers' worries about the physical availability of the commodity in question. If inventories are low relative to demand for the commodity, buyers become concerned about supply disruptions and delivery risk. To avoid this risk, they want to own the physical commodity rather than the futures contract. This causes them to bid up the spot price to a level above the futures price (producing backwardation). This increase in the spot price is known as the “convenience yield.” (For more on this theory, we recommend the following: “The Convenience Yield and Risk Premia of Storage” by Dincerler, Khokher, and Simin; “Equilibrium Commodity Prices with Irreversible Investment and Non-Linear Technologies” by Casassus, Collin-Dufresne, and Routledge; and “Pricing LME Commodity Futures Contracts” by Richard Heaney).

As you can see, the two theories - hedging pressure and convenience yield - are not mutually exclusive. The first focuses on price risk, while the second focuses on liquidity (delivery) risk. In fact, in their paper “Hedging Pressure, Delivery Risk and Risk Premium in Futures Market: Empirical Evidence”, Kang and Roongsangmanoon conclude that both theories are at work in commodity markets, and that their interaction produces non-linear price effects. Bowman and Husain from the International Monetary Fund reach a similar conclusion in their paper “Forecasting Commodity Prices: Futures Versus Judgement.”

Now that we have defined them, let's next look at the reliability of our five sources of return on a commodities index fund.

As we have noted in many previous articles, while differences between bond yields and two countries are a good theoretical indicator of likely exchange rate changes, history has shown that the actual process is quite close to being random.

In contrast, collateral return is undoubtedly the most reliable source of return, and is primarily influenced by the level of prevailing interest rates. To a lesser extent, it is also affected by the specific bonds investments used by the commodity fund manager (e.g., nominal versus real return bonds), and any active management skill the manager brings to the collateral bond portfolio.

As Erb and Harvey have noted, the diversification return is also reasonably reliable. On the other hand, they also show how unexpected spot returns and roll returns often net out to zero for many commodities over long periods of time. This is consistent with the findings of an IMF paper by Cashin and McDermott. In “The Long-Run Behavior of Commodity Prices,” they find that a slow long-term decline in real commodity prices is, for all practical purposes, overwhelmed by their year-to-year variability (i.e., by cyclical factors).

Taking all these factors into consideration, in our forward looking asset pricing models, the long term return on a commodities index fund is principally determined by the diversification return, which we assume to be four percent. This is added to the real bond yield (a proxy for the collateral return) to generate the total estimated return.

Let's now move on to the question of whether commodities index funds are overvalued today. An important starting point is a theory of how commodity prices should evolve over the business cycle. The following table summarizes a common view, based on the convenience yield (inventory) approach. In essence, as the economy emerges from recession, commodity inventories are drawn down, which triggers an increase in the spot price. This induces commodity producers to bring older capacity (with higher operating costs) back online, and, eventually, to increase in new capacity. However, the latter usually happens late in the cycle, so that much of the new capacity comes online after the economy has peaked. This causes commodity inventories to peak as economic demand hits bottom.

Economic and Commodity Demand	Bottoming	Strengthening	Peaking	Weakening
Commodity Supply	Falling (old capacity taken offline)	Bottoming (highest cost capacity retired)	Rising (old capacity reactivated)	Peaks (new capacity comes on)
Commodity Inventories Relative to Demand	Peaking	Falling	Bottoming	Rising
Spot Prices	Bottoming	Rising	Peaking	Falling
Futures Prices Relative to Spot Price	Contango (futures higher than spot)	Uncertain	Backwardation (futures lower than spot)	Uncertain
Profitability of long commodity futures position, before positive diversification and collateral yields	Negative (falling spot and negative roll yield)	Uncertain (rising spot, uncertain roll yield)	Positive (rising spot and positive roll yield)	Uncertain (falling spot, uncertain roll yield)

One critical aspect of this cycle, which is very relevant to the valuation issue, is that, as economic demand peaks, the old commodity production capacity that comes back online often has significantly higher operating costs. In effect, the supply curve becomes much steeper. Along with declining inventories, this helps drive up spot prices - often by a significant amount. However, this has two important consequences, which together increase price volatility and the likelihood of positive and negative spot returns for investors in commodity futures. First, when the supply curve becomes steep, even a small fall in demand can cause a sharp drop in spot prices. And it is always the case that, beyond a certain point (say, $3 per gallon gasoline in the United States), continued increases in the price of a commodity cause a fall in demand. This is one of the factors that make commodity market tops so fragile.

On the other hand, the older commodity production capacity put back in service is often unreliable. Hence, periods of high economic demand are also those most subject to what are known as “unplanned outages” or “supply disruptions" that serve to increase customer nervousness and cause even sharper rises in spot prices. Recent years have seen a sharp increase in demand for many commodities, driven by strong overall economic demand growth, particularly in China. It is therefore reasonable to believe we are in the most dangerous phase of this physical commodities cycle.

To this normal cyclical process, (which varies in intensity, depending on the commodity in question), we have to add two new financial factors. The first is the sharp increase in commodity index funds that are buyers of commodity futures contracts (i.e., providers of commodity price insurance). While the increase in commodity production due to rising economic demand has no doubt increased the demand for commodity price insurance, it seems likely that this has been outmatched by an even bigger increase in supply of insurance available from commodity index funds. On balance, it seems likely that, from the hedging pressure perspective, the size of potential roll returns has declined (we should also note that this is further compounded by the inability of commodity index funds to be sellers of futures contracts to earn roll returns in contango situations).

The second new financial factor is the entry of hedge funds and other active investors into commodity futures markets (as both buyers and sellers) in search of short-term gains driven by spot returns and high volatility. Given their documented tendency to follow momentum trading strategies, it is not unreasonable to conclude that the increase in financial speculation in commodities will cause prices to overshoot levels justified by the normal physical cycle.

Indeed, at a time when the case for continued global demand growth seems weaker and weaker (e.g., with both the U.S. Federal Reserve and European Central Banks raising interest rates), the increases (through the end of February) in the Economist Commodity Price Indices over the last year have remained very strong: 13.6% (in U.S. Dollar terms) for the overall index, and 25.7% in Euro, 26.0% in Yen and 24.6% in U.K. Pounds. In subgroups, the increase has been even more impressive: industrial metals, 28.5% (in U.S. Dollars), oil, 19.4%, and non-food agricultural products, 14.4%.

All of these considerations lead us to conclude that we are now at or very close to the top of the price cycle for many commodities. While we continue to believe that our assumed return of real bonds plus four percent is a reasonable long-estimate for commodity index futures as an asset class, there is a high probability that short term returns will be much lower. As always, we note the difficulty of trying to time markets. If an investor has already made his or her allocation to commodities, and if that allocation is currently above its target portfolio weight, this would be a good time to rebalance, perhaps to a level somewhat below the target weight. On the other hand, if an investor has not yet made his or her allocation to commodities, we believe that the prudent course of action would be to defer any reallocation until commodity prices have come down from their current levels.

Update April, 2005

The Basic Return Generating Process

We should very clearly specify from the beginning that our allocation to commodities is based on an investment in commodities futures. Both of the commodity index funds available to investors today track indexes that are based on continuously rolled over positions in commodities futures. A recently published working paper by Gorton and Rouwenhorst ("Facts and Fantasies About Commodity Futures") shows why it usually makes sense to have these in your portfolio. The paper analyzes the performance of an equally weighted index of commodity futures that over the period beginning in July, 1959 and ending in March, 2004. This research is relevant to index investors, because the currently available commodities index funds are all based on investments in commodities futures. However, these funds are based on underlying indexes (the Goldman Sachs Commodities Index and the Dow Jones - AIG Commodities Index) that use unequal weights for different commodities (based, for example, on their relative importance in the economy). For simplicity the Gorton and Rouwenhorst study uses an equally weighted index of 34 different commodities. Despite this difference, this study's findings are extremely interesting.

The authors begin by noting that "the economic function of corporate securities such as stocks and bonds is to raise external resources for a firm." In contrast, "commodity futures are quite different; they do not raise resources for firms to invest [in their operations]. Rather, commodity futures allow firms to obtain insurance for the future value of their outputs or inputs. Investors in commodity futures receive compensation for bearing the risk of short-term commodity price fluctuations…Because foreseeable trends in spot [i.e., physical] market commodity prices are taken into account when the futures price is set, expected movements in the spot price are not a source of return to an investor in the futures. Rather, purchasers of futures contracts [earn positive returns] when the spot price at the maturity of the futures contract turns out to be higher than expected when they purchased the contract. They lose when the spot price is lower than anticipated. A futures contract is therefore a bet on the future spot price, and by entering into a futures contract an investor assumes the risk of unexpected movements in the future spot price."

However, since "unexpected deviations from the expected future spot price are by definition unpredictable, they should average out to zero over time…What then is the [source of] the return an investor in futures expects to earn? The answer is the risk premium, which is the difference between the current futures price and the [slightly higher] expected future spot price."

The authors then go on to compare the historical returns on their commodities futures index with those on other asset classes. Over the 43 year period they cover, their commodity futures index delivered average annual nominal returns of 11.02% (in U.S. Dollars), with a standard deviation of 12.12%. During this same period, the S&P 500 also had average annual returns of 11.02%, but with a standard deviation of 14.90%. The premium over bond returns for both asset classes was 3.31%.

Equally as important were the correlations of returns the authors found. On an annual basis, the correlation between stock and commodity returns was negative (.11) -- in other words, when stock returns declined, commodity futures returns tended to rise. Moreover, this negative correlation increased to (.44) when five year holding period returns were compared. In other words, the diversification benefits from holding commodities in a portfolio increase for investors with longer time horizons. To put this in a slightly different context, the authors found that "during the 5% of the months with the worst performance of equity markets, when stocks fell on average by 9.18%, commodity futures experienced a positive return of 1.43%."

The correlation with inflation was also very interesting. For stocks it was negative (.19). While this was better than bonds (.33) correlation, it was still negative -- returns on both asset classes tended to decline when inflation increased. In comparison, the correlation between commodity returns and inflation was positive .31. In short, as a hedge against inflation, commodities were superior to stocks and bonds. Finally, the authors also found that the returns on their commodity index were positively skewed, while those on equities were negatively skewed. The authors concluded that "the slightly higher [standard deviation] of equities, and the opposite skewness [from commodities] together imply that equities have more downside risk relative to commodities."

Just to make sure that their conclusions weren't solely applicable to the United States, the authors repeated their analysis from the perspective of investors located in the UK and Japan. Their results were the same. Finally, the authors tested the performance of their commodity futures index against an index comprising the shares of commodity producing companies. They found that "over the 41 year period between 1962 and 2003, the cumulative performance of the commodity futures index was triple the cumulative performance of the matching equities index." In sum, the authors conclude that "the diversification benefits of commodity futures work well when they are needed most."

Commodity Index Funds

Until the launch in the United Sates of PIMCO's Commodity Real Return Fund (PCRDX), if you wanted to invest in a commodities index fund you only had one choice: The Oppenheimer Real Assets Fund (QRAAX for the Class A Shares).

QRAAX tracks the Goldman Sachs Commodities Index. The front end sales charge on this fund is steep: 5.75% on the Class A shares (the Class B shares carry a deferred load which declines to zero if the shares are held for more than six years, while the Class C shares carry a 1% deferred sales load for the first year they are owned). The annual expenses on the Oppenheimer Fund are also relatively high: 1.68% per year for the Class A shares, 2.45% per year for the Class B shares (for the first six years, after which they convert to Class A shares), and 2.45% per year (forever) on the Class C shares. (Note that if the shares are held for five or more years, the Class B shares are the least expensive to own, and the Class C shares the most expensive).

The PIMCO Commodities Real Return Fund tracks the Dow Jones/AIG Commodities Index. The sales load on the Pimco fund Class A shares is up to 5.50%, while the annual expense ratio is 1.24% (on the A shares). Clearly, from a pricing point of view, these are not "typical" index funds. We have been asked in the past how our asset allocation recommendations would be changed, if at all, if we took the front-end loads and relatively high expenses charged by these funds into account.

We have taken two approaches to this issue. First, we calculated the expected value of different share classes of the Oppenheimer Real Assets Fund after different holding periods, based our underlying asset class real return assumptions (expected annual return of 8.1%, and standard deviation of 18.3%). In our analysis, the fund's Class A shares had a front end load of 5.75%, and an annual expense charge of 1.49%. The Class B shares had no front-end load; their annual expense charge was 2.44% through year six, after which it was 1.49%. The Class C shares also had no front end load, but charged annual expenses of 2.40% throughout their holding period. Our analysis was undertaken from the perspective of a long-term investor. The following table shows the expected value of the different share classes (based on an initial $1,000 investment) after holding periods of different length.

Holding Period	Class A Shares	Class B Shares	Class C Shares
6 Years	$1,374	$1,376	$1,379
10 Years	$1,767	$1,769	$1,709
20 Years	$2,420	$2,423	$2,234

This table certainly makes one thing clear: let it never be said that the folks at Oppenheimer don't have sharp pencils! As you can see, for a long-term investor, there is basically no difference between the expected value of the Class A and Class B shares. The Class C shares are another story, however, and seem better suited to people who don't expect to own the fund for very long.

Our second analysis looked at what would happen to our model portfolio asset allocations if we reduced the expected return on the commodities asset class to reflect the incremental expense (above that of a "typical" index fund) associated with the Oppenheimer fund. We chose to use our U.S. dollar 7% target real return portfolio in our analysis. While keeping the commodities asset class standard deviation unchanged, we reduced its expected return from 8.10% to 6.86%, reflecting the Oppenheimer Real Asset Fund's "extra" expenses of 1.24% (1.49% less a "normal" index fund expense ratio of .25%). We tested the impact of this change using both historical asset class returns and expected future returns as inputs into our simulation optimization model. In the former case, we found that the change had some impact, resulting in a 5% reduction in our allocation to commodities, and a 5% increase in our allocation to domestic equity. However, in the simulations based on expected future returns, the reduced commodities return had no impact on our asset allocation. However, this analysis comes with one important caveat: we deliberately used the most expensive commodities index fund (QRAAX) in this analysis. Had we chosen the PIMCO Commodities Real Return Fund institutional shares that are available through many fund supermarkets, (which have a relatively low .75% expense ratio), we suspect there would have been no impact at all on our asset allocations.

In addition to QRAAX and PCRDX, one also sometimes hears about the "Rogers Raw Materials Fund." This is a privately placed fund that is not available to individual retail investors. It tracks the Rogers Raw Material Index.

The following table compares the weightings given to different commodities in the three different commodities indexes that are tracked by these three different funds. As previously noted, the Goldman Sachs Commodities Index (GSCI) is tracked by the Oppenheimer Real Assets Fund (QRAAX), which, in U.S. dollar terms, was up 32.14% through the end of November, 2004. The Dow Jones AIG Commodities Index is tracked by the PIMCO Commodities Real Return Fund (PCRDX). Through the end of November, it was up 20.50%. The main cause of the difference was the relatively lower weight of energy commodities in the DJ/AIG Index. On the other hand, this lower energy weighting has historically made the DJ/AIG somewhat less volatile compared to the GSCI.

Finally, according to www.rogersrawmaterials.com, the RRM Index was up 27.11% through the end of November (the latest data available on the website as December 31, 2005- date of this publication). Unsurprisingly, its energy weighting is in between those of the GSCI and the DJ/AIG. Should a reasonably priced individual investor-oriented fund that tracks the RRM Index ever come to market, we will include it among the commodity index funds that we follow.

Commodity	DJ/AIG	GSCI	RRM
Natural Gas	12.3%	11.3%	3.00%
Crude Oil	12.8%	39.9%	35.00%
Unleaded Gas	4.1%	7.5%	3.00%
Heating Oil/GasOil	3.9%	13.0%	3.00%
Live Cattle/Feeder Cattle	6.2%	4.4%	2.00%
Lean Hogs	4.4%	2.2%	1.00%
Wheat	4.9%	4.0%	7.00%
Corn	5.9%	2.8%	4.00%
Soybeans	7.6%	1.7%	3.15%
Soybean/Palm Oil	2.7%	0.0%	2.00%
Canola	0.0%	0.0%	0.67%
Orange Juice	0.0%	0.0%	0.66%
Rice	0.0%	0.0%	2.00%
Azuki Beans	0.0%	0.0%	1.00%
Barley	0.0%	0.0%	0.77%
Oats	0.0%	0.0%	0.50%
Aluminum	7.1%	3.1%	4.00%
Tin	0.0%	0.0%	1.00%
Copper	5.9%	2.4%	4.00%
Lead	0.0%	0.3%	2.00%
Zinc	2.7%	0.6%	2.00%
Nickel	2.6%	0.8%	1.00%
Gold	6.0%	2.1%	3.00%
Silver	2.0%	0.2%	2.00%
Platinum	0.0%	0.0%	1.80%
Palladium	0.0%	0.0%	0.30%
Sugar	2.9%	1.5%	1.00%
Cotton	3.2%	1.0%	3.00%
Cocoa	0.0%	0.3%	1.00%
Coffee	3.0%	0.8%	2.00%
Rubber	0.0%	0.0%	1.00%
Wool	0.0%	0.0%	1.00%
Silk	0.0%	0.0%	0.15%
Lumber	0.0%	0.0%	1.00%
	100.0%	100.0%	100.00%

The following table shows that while the returns on all three of these commodity indexes are highly correlated with each other, they have very low correlations with other asset classes, as shown in the following table:

GSCI Correlation with Other Major Asset Classes, by Currency

	USD*	AUD	CAD	Euro	JPY	GBP
Domestic Equity	(.10)	(.20)	.26	.14	.14	.10
Domestic Bonds	(.06)	.16	(.14)	(.33)	(.21)	(.26)
Global Equity	(.05)	(.14)	(.38)	.19	.22	.12
Global Bonds	(.21)	(.03)	(.43)	.05	.43	.09

* For U.S., we use international (non-U.S.) equity and bonds; data covers 1988-2002

Given all these considerations, our preferred choice is the no sales-load Class D shares of the PIMCO fund (which tracks the DJ-AIGCI).

However, people who cannot access the no-load PIMCO shares (PCRDX) are still left with a difficult choice. Both the Oppenheimer and the Pimco funds’ "A" shares are still very expensive as index funds go, not only in terms of their operating expense ratios, but also due to the fact that they carry front end sales loads (which are almost never charged by index funds). Inevitably, this raises the questions about what is driving these high costs, and whether we can expect them to decline in the future.

On the one hand, the operation of a commodity index fund is quite different from that of a "normal" stock or bond index fund. Given the high costs that would be involved in holding physical commodities (transportation, storage, financing, etc.), commodity index funds instead hold a portfolio of commodity futures contracts. However, since these are leveraged instruments (that is, $1 invested in a futures contract gives you control over more than $1 of the underlying commodity), you don't need to invest the full amount of the money you have received (as the operator of the fund) in futures contracts. Both the Oppenheimer Real Assets Fund (QRAAX) and the PIMCO Commodities Fund (PCRAX) invest the remaining funds in government bonds. We prefer PIMCO's approach to this, because it primarily uses only real return bonds (U.S. Government issued TIPS). This is consistent with the role as an inflation hedge that commodities funds play in many portfolios. On balance, we believe that the additional costs inherent in operating a commodity index fund probably account for some of QRAAX and PCRAX’s relatively high (for index funds) expense ratios. However, until somebody (e.g., Vanguard or iShares) introduces a lower priced mutual or exchange traded commodity index product, we won’t know the extent to which this is the case.

On the other hand, the high front end loads charged by both QRAAX and PCRAX have nothing to do with the operation of the fund per se, but rather reflect the costs involved in distributing them (e.g., brokers’ commissions). We believe that, at this point in time, these high front-end loads reflect the difficult nature of the "sales process" for a retail commodity index fund. More specifically, we believe that most individual investors currently do not appreciate the potential diversification benefits offered by the commodities asset class, and as such are likely to regard it as a highly speculative (that is, risky) investment. Providing the education needed to overcome this initial investor resistance probably requires substantial amounts of a broker (or financial planner’s) time. Given this, Oppenheimer and PIMCO have probably had to charge a substantial front end load on their respective funds (QRAAX and PCRAX) in order to induce brokers and planners to spend the time required to sell these funds to their respective clients. Going forward, however, we believe that the average level of investor understanding of the benefits of investing in commodities will increase to the point that another company (e.g., Vanguard or iShares) will launch their own no-load mutual fund or ETF commodities index product. PIMCO’s decision to partially pre-tempt this step by making its no-load "D" shares available through mutual fund supermarket programs is very encouraging in this regard.

What About Natural Resources Stock Funds?

The high fees charged on QRAAX and PCRDX have logically led some investors to ask if they could substitute a lower cost natural resource (e.g., IGE) or energy focused (e.g., IYE) stock sector exchange traded funds (ETF) for either QRAAX or PCRAX and still receive similar diversification benefits for their portfolios (again, this assumes that an investor does not have access to PCRDX). GASFX would be another example of this approach.

Unfortunately, the answer as to which approach makes the most sense isn't clear-cut.

Over most periods of time during which all these funds have been in existence (and this is admittedly a small data set), the returns on the two commodity funds have pretty closely tracked the returns on the sector stock index funds (which invest in the shares of companies which produce the commodities, and products based on them). However, there have been periods during which the returns significantly diverged. Specifically, during the big stock market downturn we experienced in 2001 - 2002, there were periods during which the return on the commodity funds was positive (and therefore provided the kind of diversification benefit most investors seek from the commodities asset class), while the return on the natural resources stock index funds were negative (though by less than the negative return on the overall equity market). In short, during strong equity market downturns, it seemed that the equity market factor overwhelmed the commodity market factor in determining the return on the natural resources stock sector funds. As a result, people who invested in natural resources stock sector funds hoping for a diversification benefit from investing in commodities got a smaller one than they had expected.

From our perspective, the bottom line is this: the best solution for everyone will be the introduction of a no-load commodities index mutual fund, or, alternatively, a commodities index exchange traded fund. Until that happens, one is left with a choice between relatively expensive commodity index products, or less expensive, but also potentially less effective, natural resources stock sector index funds. As previously noted, the exception to this are the no-load Class D shares of the PIMCO fund. Unfortunately, they aren't available to all investors today. For a long-term investor without access to PCRDX, the sales load on either QRAAX or PCRAX could potentially be offset relatively quickly by the diversification benefits either of these funds would produce for a portfolio. On the other hand, we also respect those investors who, on principle, cannot bring themselves to pay the current front-end loads charged by these funds. For them, the choice is apparently either the lower costs and lower diversification benefits offered by natural resources stock sector funds, or waiting until a low cost commodity index fund product is introduced.

What About Commodity TRAKRS?

There is one other vehicle that tracks the Dow Jones AIG Commodities Index, but it is an unusual one. "Total Return Asset Contracts" were recently launched by Merrill Lynch, and are perhaps better known by their brand name "TRAKRS". Technically, they are neither mutual funds nor exchange traded funds: they are futures contracts, but of a very special type. Unlike typical futures contracts, they can be through a brokerage account, and do not require a separate futures trading account to be set up (although some reports suggest that other brokers may be reluctant to do this, given that TRAKRS are a Merrill Lynch product).

The reason TRAKRS can be held in a brokerage account is that unlike a typical futures contract, no leverage or margin calls are involved. Individual investors must post one hundred percent of the contract’s value when it is purchased. The value of the commodity TRAKRS fluctuates in line with the total return on the Dow Jones AIG Commodity Index. The current commodity TRAKR contract is traded on the Chicago Mercantile Exchange (www.cme.com) and expire on June 28, 2006, when they are settled for cash (presumably, Merrill will introduce another contract at or before this date, to enable investors to maintain their position in this asset class). TRAKRS can also be sold before maturity. TRAKRS are not treated like other futures contracts for tax purposes, and instead become eligible for capital gains treatment after they have been held for more than six months. Because they are futures contracts, TRAKRS pay no dividends; the only taxable event occurs when they are sold or expire.

Another attractive feature of TRAKRS is that, because they are futures contracts, they carry no annual operating expense charges. There are, however, other costs involved in owning them. First, there is a brokerage commission when they are purchased (similar to the brokerage commission one pays when buying an exchange traded fund). Second, due to the structure of the contracts themselves, TRAKRS typically trade at a slight premium to the underlying index value. This premium has been estimated to be about three percent, on average.

How, then, would you evaluate the trade-off between the PCRAX mutual fund and the commodity TRAKR? There are a number of issues involved. The first is the relationship between the front-end load on PCRAX and the combined brokerage commission and price premium on the TRAKR. Let’s assume (unrealistically, but for the sake of illustration) that the sales load equals the brokerage commission. The question then becomes what discount rate should you use to convert the three percent price premium to an annual equivalent fee (analogous to a fund operating expense charge) over three years? Logically, the rate you use should reflect the opportunity cost of that money - that is, the rate you could otherwise earn on the TRAKR premium charge. To keep this example nice and tidy, let’s assume that this discount rate is what you would expect to earn if you invested that three percent in PCRAX. The breakeven discount rate that would make your three percent estimated TRAKR premium equal to the 1.24% annual expense charge on PCRAX is 11.5%. If you expected to earn more than this each year on PCRAX, it would appear to be a better deal than the TRAKR, assuming that the front end load on the former was equal to the brokerage commission on the latter.

But of course, this assumption isn’t true - the front end load on PCRAX is probably much higher than the brokerage commission you would pay to buy the TRAKR (though because the latter is a futures contract, you should check on the size of that brokerage commission in advance). This means that the breakeven opportunity cost is actually much higher. For example, if the difference between the sales load and the brokerage commission reduces the effective TRAKR price premium to 2%, the breakeven discount rate rises to over 38%. In this case, it seems like the TRAKR is a cheaper way to gain exposure to the commodities asset class. However, this assumes a three year holding period. If your expected holding period is shorter -- remember, the initial TRAKRS contracts mature in June, 2006, and if the three percent premium continues (even on the shorter maturity contract), the breakeven discount rate will be lower, and PCRAX may still be a better deal.

On the other hand, what about the case where you can purchase the PIMCO "D" shares without a front-end load? In this case, the TRAKRS don’t look like such a good deal. If you assume the brokerage fee to purchase the TRAKRS equals 0.25% (twenty-five basis points), the breakeven rate of return falls to only 7.00%. If you expect the Dow Jones AIG Commodity Index to increase by more than this much per year over the next three years, you would be better off investing in the PIMCO "D" shares and giving TRAKRS a pass.

The bottom line is that TRAKRS are new, different, but potentially very interesting products. In addition to commodities, TRAKRS have been introduced that track gold as sell as the Euro/U.S. dollar exchange rate. If you don’t have access to the PCRDX shares, and are looking for a cheaper way to invest in the commodities asset class, at least for the next two and a half years, TRAKRS may make sense if you don’t mind the additional operational hassles that investing in them entails. For more information, visit www.trakrs.com.

What About Gold?

The long anticipated launch of a U.S. gold-based Exchange Traded Fund finally happened in November, and quickly attracted over $1 billion in assets. Trading under the ticker GLD, and with an expense ratio of just 0.48%, the new ETF resembles similar offerings already available in the U.K., Australia and South Africa. The ETFs are designed to trade at a price equal to ten percent of the prevailing price for an ounce of gold. In addition, they are backed by an amount of physical gold equal to ten percent of the notional physical volume represented by the ETF. For example, if the total value of the ETFs outstanding represent 1,000 ounces of gold, the shares would be backed by 100 ounces of physical gold. Supporters of this new product claim that it is much cheaper to own gold this way, because you avoid many costs associated with storing and safeguarding the physical product (e.g., gold coins you directly purchase and hold in a bank safety deposit box). Detractors claim that because the ETFs are only fractionally backed by gold there is still a large difference between this new financial product and, for example, having a pile of gold coins in your safety deposit box.

We also have concerns about this new product, but they are of a different nature. First, as described in this month's letter to the editor, there is a significant difference between the source of returns from owning a physical commodity versus owning a futures contract on that commodity. In our opinion, direct ownership of a physical commodity is a more speculative investment than a continuously rolled over futures position. In other words, as a financial investment, we'd be more comfortable with an ETF tied to the gold futures contract that trades on the New York Mercantile Exchange.

Our second concern is with the treatment of gold as a separate asset class. We have included it as part of the broader commodities asset class. Our reasoning is as follows. Between 1976 and 2000, the total return on gold, in U.S. dollars, had a very low correlation to the total return on other asset classes, including (as measured by the Goldman Sachs Commodities Index, in which gold has a very low weighting). The specific correlations were as follows: U.S. Investment Grade Bonds (-.01); U.S. High Yield Bonds (.03); U.S. Commercial Real Estate Investment Trusts (.05); Goldman Sachs Commodities Index (.25); U.S. Equities (.04); Foreign Equities (EAFE) (.22). These low correlations suggest that a strong argument can be made for gold as a separate asset class.

On the other hand, over the same period, the average annual return on gold was much lower, and the standard deviation of returns was much higher, than it was for these other asset classes. On balance, this more than offset the advantages of gold's low correlations, and caused most asset allocation software programs (including ours) to reject an allocation to gold. However, this still leaves unanswered the question of whether there exists a set of circumstances under which an allocation to gold would make sense.

As we have written, we like to think of the economy as being in one of three states: normal (cyclically varying real growth with low to moderate inflation), high inflation, and deflation. Traditionally, people looked at gold as a hedge against inflation. However, in recent years the total returns on gold have not been closely correlated with inflation. Broadly speaking, this has weakened the argument for investing in gold, and led people to look to commodities (more broadly defined) and real return bonds as hedges against inflation risk. The remaining question is therefore how gold would perform under a period of extended deflation. The traditional asset of choice for hedging against this risk is investment grade bonds. Moreover, as a commodity, one would generally expect to see the price of gold (and the returns on holding it) decline during a period of deflation.

However, this argument neglects gold's other historical role as a store of value and unit of exchange (note that this only applies to physical, monetary gold -- i.e., coins). One could therefore envision a scenario in which prolonged deflation (and expectations of an eventual sharp reflation) led people to lose faith in the long-term value of a currency (and/or a domestic debt market). Under these circumstances, in its role as a monetary unit, gold's attractiveness (and the returns earned by holding it) might sharply increase. Unfortunately, the world's recent experience with deflation has, thankfully, been so limited that very little data is available to support or contradict this scenario. Given this, we will continue to view gold as a potential tilt within the larger commodities asset class, rather than a separate asset class in itself. Moreover, if one intends to take such a tilt, the most logical implementation strategies seem to be gold futures contracts or gold coins, rather than the current gold ETF.

Last But Not Least: Don’t Forget About Timber

Unfortunately, neither the Goldman Sachs Commodities Index (tracked by the Oppenheimer Real Assets Fund) nor the Dow Jones - AIG Commodities Index (tracked by the Pimco Commodities Real Return Fund) currently includes timber in its mix of commodities. This leaves an investor with a number of alternatives for including this in his or her overall position in the commodities asset class. First, he or she could continuously role over a position in lumber futures contracts. As we have noted, this is our preferred means of investing in commodities (e.g., it is the way the GSCI and DJ/AIG Indexes are contructed). Unfortunately, the operational details involved put this approach beyond the practical reach of most investors. A second alternative would be to buy a mutual fund that only invests in the common stocks of companies involved in the forest products industry. An example of this is the Fidelity Select paper and Forest Products Fund (FSPFX). However, a fund like FSPFX contains exposure not only to timber prices, but also to the overall equity market. As such, during different periods, one or the other factor may dominate in determining the fund's return.

A third alternative for investing in timber would be to purchase one or more of the growing number of large timber holdings that have been structured as real estate investment trusts (REITS), and/or master limited partnerships (MLPs). Plum Creek Timber (PCL) is one of the largest of these, with eight million acres of holdings divided between northern and southern forests. Rayonier (RYN) is another, with two million acres in holdings. How have these direct timber investments performed over time? Between 1989 and 2003, Plum Creek delivered more than twice the return of the S&P500, though with about half again as much risk. Over a longer period (1957 to 2003) one index of raw timber prices (maintained by the state of Indiana) has delivered a real compound annual return of 1.2%.

Based on these considerations, we can understand why an investor might want to include timber as part of his or her allocation to the commodities asset class. Until timber is included in the main futures-based commodities indexes, we believe that the best way to do this is via direct investments in vehicles like PCL and RYN.

Update: From our March, 2005 Issue

A Deeper Look at Commodities Returns

Historically, commodities have delivered real returns roughly equal those on domestic equity. While their volatility has typically been higher, their correlation with most other asset classes has been very low (with the exception of real return bonds). As a result, including commodities has historically provided substantial diversification benefits (see, for example, "Strategic and Tactical Allocation to Commodities for Retirement Savings Schemes" by Nijman and Swinkels).

With the benefits of commodities as an asset class being recognized by more investors, they are also receiving increasing attention from academic researchers. A number of interesting papers have recently been published, which we will review in this note. To understand the arguments, made in them, we need to review some rather arcane technical aspects of commodity futures pricing. Please bear with us!

A futures contract is a promise entered into with a commodities exchange (e.g., the New York Mercantile Exchange) to deliver (when you sell a futures contract) or receive (when you buy a futures contract) a specified quantity of a specified commodity at a specified date in the future -- for example, 1,000 barrels of oil, at a price of $40 per barrel, 12 months from today. However, rather than delivering or receiving the actual physical commodity, most sellers and buyers of futures contracts buy or sell an offsetting contract at the specified maturity date.

Commodity indexes, such as the Goldman Sachs Commodities Index, or the Dow Jones-AIG Commodities Index, are weighted baskets of different commodity futures. Funds that track these indexes (e.g., the Oppenheimer Real Assets Fund -- QRAAX or the PIMCO Commodities Real Real Return Fund -- PCRDX) are net buyers of commodities futures contracts (this is also known as being "long futures").

The return generating process within a commodity index fund is complex, and has three parts. The first is the return they earn on their excess cash. A futures contracts is purchased on margin, which means that you pay less than 100 percent of its face value when you initially buy it. As long as this futures contract's price is lower than the spot price, the margin requirement is usually quite small (if the spot price drops below the futures contract's price, the commodities exchange may demand more cash -- a so-called "margin call" -- to limit its credit risk exposure). For example, let's say an investor buys a share of a commodity index fund for $100. Let's further assume that the fund manager has to spend only $10 to purchase $100 of futures contracts on the commodities that make up the index being tracked. That leaves $90 in excess cash that can be invested to earn a return that is unrelated to the earnings on the futures contracts. Theoretically, there is no constraint on where that $90 might be invested. It could, for example, be invested in emerging market equity shares. However, this might create marketing problems for the commodity index fund, since its returns would therefore be a mix of two volatile asset classes – commodities and emerging markets equities. To avoid this problem, commodity index funds typically invest their excess cash in low volatility asset classes, such as nominal or real return government bonds.

The second source of the return on a commodity index fund is the diversification benefit that results from investing in a mix of different commodities whose returns have very low correlations with each other.

The third source of return for a commodities index fund is the insurance premium it earns from being a buyer of commodity futures contracts. Let's look more closely at the theoretical source of this return.

The classical argument for the use of futures contracts starts with a commodity producer, who faces relatively high fixed costs (e.g., as would be the case for a farmer, mine owner, or oil production company). This producer is assumed to sell the commodity to an intermediate customer who faces relatively variable demand from final customers for his goods. In addition, the intermediate customer is assumed to have lower fixed costs than the commodity producer. Swings in demand by final customers cause the intermediate customer to cut back his purchases from the commodity producer. Given that the producer's production is relatively fixed, this causes big swings in prices for the commodity. Unfortunately, because the commodity producer has high fixed costs, these price swings can force it into bankruptcy. Commodity producers therefore have a strong interest in hedging the risk they face from price swings.

Obviously, one way to limit these swings would be to insert a storage operator into this simple system, who buys from the producer when demand falls, and sells this accumulated inventory to the intermediate customer when demand rises. The operations of this storage provider balance swings in demand, and in so doing, keep the price for the commodity relatively stable. However, two obstacles may prevent a storage operator from entering the system. First, it may be technically impossible (or very expensive) to store the commodity in question for anything other than a short period. For example, this is the case with oil. While it is feasible to build tank farms to maintain small oil inventories, the amount of tanks that would be necessary for large inventories is prohibitively expensive. This means that most of the physical response to swings in oil demand comes not from inventory in tanks, but from changes in the amount of oil that is pumped from the ground. Apart from physical storage challenges, there may also be financial ones. If the price swings over time in a given commodity are large, so too must be the amount of equity in a storage operator's capital structure. If the capital costs of building the storage facility are large, this can create financial barriers to entering the storage business.

The financial futures markets provide an efficient alternative to physical storage as a means of managing the price risk facing commodity producers. When futures markets exist, producers can sell their production forward (i.e., sell a futures contract) to lock-in a price (and hopefully a profit) for their company. When the futures contract matures, the producer simply buys an offsetting contract, and delivers the physical commodity to a physical buyer. Theoretically, any loss or gain on the physical commodity should be almost completely offset by the loss or gain on the futures contract. Why almost? Because the buyer of the futures contract is, in effect, providing price insurance to the commodity producer, and needs to be compensated for taking this risk. However, futures contracts to not include an explicit risk premium; instead, this is created by having the futures contract trade at a lower price than the "spot price" (i.e., the price at which the physical commodity can be purchased for immediate delivery). In the arcane language of the commodities markets, the fact that futures contracts trade at lower price than the spot price is known as "normal backwardation", or simply "backwardation." The buyer of the futures contract therefore earns her risk premium in the form of the difference between the lower price at which she buys it, and the higher price at which she sells it (which assumes that, as the futures contract nears maturity, its value rises to match the level of the spot market price).

Simple enough, right? However, as is true in most areas of life, sometimes that futures markets don't behave according to this theory. Specifically, there are times when the spot price is actually lower than the futures price. In the language of commodities, this is known as "contango", which has nothing to do with a dance from Argentina.

Why might a commodity be in contango? First, a market may experience an unexpected increase in supply (e.g., think of oil producing nations breaking their OPEC production quotas), or an unexpected fall in demand (e.g., the impact of the discovery of mad cow disease in Canadian beef). In this case, one would expect adjustments in supply and demand that returned the market to a state of "normal backwardation." An alternative theory has also been advanced that proposes the existence of more consistently "contangoed" markets. For example, consider a breakfast cereal producer that, through effective marketing, has created a steady demand for its products. One of its most important input costs is grains -- e.g., wheat and corn. To limit variation in its reported profits, it may purchase futures contracts to lock in its grain costs. Assuming there are also financial investors bidding for a finite supply of futures contracts being sold by farmers, the price of the futures contract may rise above the spot price for the grains. In this situation, the net provider of price insurance would not be the party buying the futures contracts, but rather the party selling them, since at maturity (when the futures price moves to the level of the spot price) the seller will be able to purchase an offsetting futures contract at a lower price than he received for the one he originally sold.

Careful readers will, like us, probably be shaking their heads at this argument. Why? Because it presumes that, having just received a negative risk premium on the futures contracts they bought, the financial investors would repeat their mistake. We think this is unlikely to happen, as such investors would, over time, abandon a market with such unattractive structural features.

One of the most interesting of the recent papers on commodity investing is ""The Tactical and Strategic Value of Commodity Futures" by Erb and Harvey. In their paper, the authors analyze the returns earned on long positions in different commodity futures between December, 1982 and May, 2004. They assume that the presence of positive average returns implies a market that was, on average, backwardated, while negative average returns would imply a market that was, on average, contangoed. Specifically, Erb and Harvey measure the "excess return" on the commodity futures above the return on three month treasury bills. Assuming the latter is approximately equivalent to inflation, Erb and Harvey's measure of "excess returns" is roughly equal to real returns.

The following table summarizes their findings:

Commodity	Average Annual Excess Return over 3 mos. T-Bill	Standard Deviation of Excess Returns
Heating Oil	10.51%	32.55%
Live Cattle	5.94%	13.98%
Live Hogs	0.17%	24.21%
Wheat	-3.32%	21.05%
Corn	-3.32%	22.65%
Soybeans	1.92%	21.49%
Sugar	3.69%	38.65%
Coffee	0.85%	39.69%
Cotton	2.60%	22.64%
Gold	-4.81%	14.36%
Silver	-5.30%	25.03%
Copper	9.15%	25.69%
GSCI Index	5.81%	16.97%

This table makes a number of interesting points. Erb and Harvey point to the much lower standard deviation of returns on the GSCI compared to those on the twelve individual commodities as evidence of the substantial diversification return provided by the index.

They also note that support for "normal backwardation" (which would be indicated by a positive average excess return) appears to be uneven, with some commodities apparently more often in contango. This leads them to conclude that "long-only" commodities futures indexes like the Goldman Sachs Commodities Index or the Dow Jones AIG Commodities Index are inefficient ways to invest in commodities futures. This leads them to two proposals. The first is for a "long/short" commodity fund that would permanently have long positions in commodities that, historically, have on average been backwardated, and short positions in those commodities that have, on average, been contangoed. In both cases, the commodity fund would be earning a premium for providing price insurance.

They also show how an active approach could be implemented at the index level, using GSCI futures. They note that "since the inception of GSCI futures trading in 1982, the GSCI has been backwardated as often as it has been in contango. The annualized payoff from buying the GSCI when the term structure is backwardated is 11.2%. However, when the term structure is contangoed, the annualized excess return is negative (5.0%)." This leads them to propose an active management strategy that buys GSCI futures when the index is backwardated (as evidenced by a positive return over the previous year), and sells them when it is contangoed (as evidenced by a negative lagged return). On a backtested basis, they find that this strategy would have generated an excess return of 8.2% per annum over the period they studied.

Besides Erb and Harvey, other researchers have also identified commodities active management strategies that would have delivered higher returns than the index had they been used in the past. For example, in "Dynamic Commodity Timing Strategies" by Vrugt, Bauer, Molenaar, and Steenkamp the authors investigate various timing strategies, models and indicators that could be used in an active management strategy. They conclude that "variation in commodity future returns is sufficiently predictable to be exploited by a realistic timing strategy." Similar papers include "An Anatomy of Futures Returns: Risk Premiums and Trading Strategies" by de Roon, van den Goorbergh, and Nijman and "Conditional Means, Volatilities, and Correlations in Commodity Futures Markets" by Chong and Miffre (which also finds that long-only commodities strategies provide excellent diversification benefits during recessions).

However, another paper provides an important cautionary tale about the dangers of depending too heavily on the accuracy of a relatively short period of backetested results as a guide to a commodities active management strategy. In "Backwardation in Energy Futures Markets: Metallgesellschaft Revisited" Carupat and Deaves describe how, in early 1990s, MG lost an enormous amount of money using futures to hedge its long term gasoline and heating oil physical delivery contracts (the actual loss was caused by the company selling at a loss futures contracts on which it had had to post rapidly increasing amounts of cash collateral). MG's strategy was premised on the continuation of backwardation in crude oil futures markets. The authors find that, using data available to MG (1984 to 1992), risk of contango appeared acceptable to MG at the time the strategy was undertaken -- the probability of negative returns at least as large as the ones MG actually experienced was "only" 3.77%, based on backtesting the available data. However, when the authors backtested a longer data set that extended to 2000, they found that the estimated probability of a disaster scenario rose to 7.32%.

So where does this leave us? As we have repeatedly noted, the underlying process that generates asset class returns is very complex, and broadly composed of two subparts: a fundamental process (e.g., that generates company investments, cash flows, and reported earnings) and a behavioral process (e.g., the reaction of investors to changes in the fundamentals, plus their anticipation of how other investors will react). Moreover, the way this process operates changes over time (i.e., one or both sub-parts is "non-stationary"). It is therefore non-linear, and extremely difficult to forecast accurately for any length of time. This is no less true of commodities than it is of any other asset class. We are therefore suspicious of all claims that make the potential gains from active management in commodities seem too easy. After all, if academics have discovered them, why wouldn't hedge funds use them and arbitrage away their expected excess returns?

However, this still leaves us with the question of whether the GSCI or DJAIG are appropriately designed indexes for investing in commodity futures. We believe they are, for two reasons. First, as Erb and Harvey note, both are heavily weighted towards commodities that, in the past, have typically been backwardated.

Second, think about the implications for commodity markets of the changes now underway in the world economy. The most important of these has been the rapid growth in demand for commodities by fast growing developing countries, and especially China. While this demand growth has driven up the price of many commodities, it has also caused an expansion of supply. This means that if you own a commodity producing company today, you are looking at a world with higher supply, in which the marginal demand is provided by developing countries whose economic growth rates (and hence commodity demand) are significantly more volatile than those of developed countries. While some developed country commodity markets may still have demand that is relatively more stable than supply (as in our cereal producer example), this is much less likely than before to be the case for the global market as a whole for that commodity. In sum, our view of the global economy leads us to conclude that backwardation in commodity markets -- and hence, positive insurance premiums for long-only commodity index funds -- should be more common than in the past. For both of the reasons we have cited, we continue to believe that diversified commodity index funds are an efficient and prudent way for most investors to gain exposure to the commodities asset class.