Commodities,4 when viewed in isolation, display an unfavorable balance between risk and volatility. Nevertheless, commodities improve the overall performance of a well-diversified portfolio. This happens because of the very low correlations between the performance of commodities and other asset classes.
To realize the benefits of a commodity allocation, we must be prepared to rebalance periodically in a disciplined way. This means, for example, that we must be prepared to sell down a commodities position as oil goes from $40 to $147.50 and be prepared to buy back in as oil goes from $147.50 to $40. This can be a challenge organizationally and behaviorally. In addition, of course, we will need to carefully manage the tax impact of rebalancing.
It is possible that an investor might have a fundamentally bullish view of demand for commodities based on predicted scarcity, anticipated demand from emerging economies, and so on. That would suggest a buy-and-hold strategy very different from the portfolio-based strategy examined in this chapter. In order to pursue such a strategy, the investor would have to conclude that (a) a paradigm shift has occurred that is strong enough to overcome the tidal pull of mean reversion and (b) other investors have not already reached the same conclusion and moved prices to a level reflecting that bullish view.
This section of Chapter 13 focuses on (a) the role of long indexed positions in commodities which are designed to mirror the broad commodities ...