Direct commodity investment has a place in every investment portfolio.

Commodities are often viewed as defensive asset classes. Not only do they achieve returns that cannot be replicated by combinations of traditional stocks and bonds, but they also prove to be defensive when such a strategy is needed most, e.g., responding favorably to unanticipated inflation while stocks and bonds decline. This observed characteristic stems from the inherent negative or low correlation to traditional asset classes, namely stocks and bonds. However, to be most productive, they should be used in combination with stocks and bonds to take full advantage of their independence from those assets.

The three investable commodity indexes currently available are: the Dow Jones AIG Commodity Index (DJ-AIGCI), Goldman Sachs Commodity Index (GSCI) and Standard and Poor's Commodity Index (SPCI). Each has a particular focus that serves specific needs for different investors. Products based on these indexes are traded over the counter, as well as on exchanges. DJ-AIGCI TRAKRS began trading on the Chicago Mercantile Exchange (CME) on July 1, 2003, DJ-AIG futures were launched on the Chicago Board Of Trade (CBOT) on November 16, 2001, and GSCI futures contracts have been on CME since July 28, 1992. Products based on these indexes are traded by institutional investors. Products like PIMCO Commodity Real Return Fund and Oppenheimer Real Assets Fund, linked to commodity indexes, are also made available to retail investors.

These indexes are comprised of a diverse selection of long futures contracts traded on exchanges. Their returns are a weighted composite of the returns of individual commodities, each of which is influenced by different supply and demand factors and in varied degrees. Each index is sufficiently diversified so that it is only moderately affected by an extreme return, positive or negative, in any one of its constituents.

As illustrated in Table 1, these indexes have different returns over the period January 31, 1993-January 31, 2003 and in the last one, three and five years. Moreover, in any period their returns differ substantially from the S&P 500 and ten-year U.S. Treasury Bonds. In particular, commodities indexes performed remarkably well in the year ended January 31, 2003, a year in which the stock market did poorly.

These indexes also have different volatilities as indicated by their standard deviations since 1993 and the last five years, as shown in Table 2. Their standard deviations also differ from those of stocks and bonds. Interestingly, the DJ-AIG and SPCI have lower standard deviations than stocks over the tested periods, and the GSCI has greater volatility. This further distinguishes the indexes from each other as well as stocks and bonds.

Table 3 dramatically illustrates the generally low correlation between commodities and stocks and bonds over the ten-year period. The correlations of returns vary but, generally speaking, their correlations to stocks and bonds are low and can be negative at times. In particular, over the 10-year period, with a correlation to stocks of less than 0.094 and a slightly higher 0.119 correlation to bonds, one may say this defensive asset class can have strategic importance to a portfolio over the long term. As one might expect, the commodity indexes bear high but not perfect correlations to each other due to differences in their rules of construction and maintenance.

The Sources Of Returns

An equity index has two sources of returns: stock price movements and dividends. A bond index also has two sources of returns: bond price movements and coupon payments. However, a futures-based commodity index has four sources of returns: spot, rolling, collateral and rebalancing.

Spot returns are simply the returns resulting from the underlying commodity price movements.

Rolling returns are achieved by closing one futures contract and taking a position in another futures contract having a later expiration date. This is done to avoid taking delivery of a commodity and to maintain a long position. Returns from the rolling process are possible especially when, close to a contract expiration date, nearby contracts are trading at a higher price or premium to those that are due to expire at a later date, a situation known as "backwardation." Rolling allows capturing returns from possible commodity backwardations as the contract rolls over higher-priced futures contracts into more distant lower-priced contracts.

Collateral returns result from placing margin or full face value of futures contracts with the CME which earns interest, called "T-bill yield." A fully collateralized futures position would be comparable to a long position in stocks or bonds.

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