Portfolio Design: A Modern Approach to Asset Allocation

SUMMARY—KEY FEATURES OF COMMODITY INVESTMENTS

Although there are four distinct ways to invest in commodities, this chapter has focused primarily on the method that gives the most direct exposure to commodity risk, passively managed futures contracts. The returns on futures contracts stem from two main sources, a risk premium due to the gap between futures prices and future expected prices and any forecast error in predicting these futures prices. The risk premium, termed normal backwardation by Keynes, is due to the one-sided demand of producers to hedge their production by selling the commodity in the futures market. Forecast errors can be either positive or negative. In the long run, average forecast errors should be close to zero. But at times forecast errors can totally dominate futures returns, as in years following the abandonment of the dollar’s peg to gold.

Returns on futures contracts vary widely over time. The early 1970s saw huge returns on commodities, but since that time commodity returns have been more similar to those for bonds than for stocks. The main advantage of commodity futures lies in their diversification properties. Correlations with bonds and stocks are zero or negative, so excess returns relative to CAPM are impressively large. If added to portfolios, commodities reduce risk and enhance risk-adjusted returns. They are a true alternative asset.

One type of commodity that has been singled out for separate study is gold. That’s because gold has always attracted ...