A new tool-resampled efficiency-helps create optimal allocations.

Commodities are often characterized as a defensive asset class. They bear a low to negative correlation to traditional asset classes like stocks and bonds, which are closely correlated to each other and tend to be more sensitive to the movements of financial indicators. In an unanticipated inflationary environment, commodities tend to outperform traditional assets because investors are inclined to move away from paper assets and turn toward tangibles such as commodities.

Commodities can be used as a diversifier to improve the risk and return profiles of different portfolios. Selecting the right commodities for an investor based on his or her risk tolerance and return preference, however, is not always an easy task. But a new tool-resampled efficiency-patented in 1999 can make the process easier. It helps create optimal portfolio allocations, not only with traditional assets like stocks and bonds but also with commodities. Although resampled efficiency is one of many optimization tools, Nobel laureate Harry Markowitz found that it produces more diversified and stable portfolio returns than his own mean-variance portfolio model, a pioneering development in Modern Portfolio Theory.

Investors can gain exposure to commodities by investing in commodity index or individual commodity futures contracts. A third option is mutual funds.

Futures contracts for the Goldman Sachs Commodity Index (GSCI) and Dow Jones AIG Commodity Index (DJ-AIGCI) trade on the Chicago Mercantile Exchange (CME) and the Chicago Board of Trade respectively. DJ-AIGCI also has TRAKRS, an exchange-traded fund, on CME. Although Standard and Poor's Commodity Index futures have not been listed on the New York Board of Trade (NYBOT) since July 2003, swap contracts are available based on the index.

The Commodity Research Bureau index (CRB) is an important benchmark index and can be invested in through exchange-traded futures. However, it's not ideal for investment purposes. Anthony Scamardella, managing director of marketing at NYBOT, says the commodities in the CRB are equally weighted, and that does not justify economic realities. In most other indexes, weightings vary from one commodity to another, aiming to reflect their economic or commercial importance.

Commodities can be broadly classified into three major sectors-agricultural, energy and metals-with associated futures contracts traded on different exchanges. Table 1 displays factors that have price implications on different commodity classes.

Each commodity or commodity class is governed by a different set of supply and demand fundamentals and responds differently to the same event and factor. An idiosyncratic event may have a substantial price implication on individual commodity markets, but the resulting impacts are diluted when adding all commodities together in an index.

Because of these varying responses, a uniform strategy to long or short a basket of different commodities may not be appropriate for achieving optimal returns. The strategy may be right for some commodities within the index but not for others. Investment savvy is called for, and trading strategies should be flexible and individually tailored for each commodity.

"Each of the three sectors, being agricultural, metals and energy, is governed by different production cycles and economic demand and supply factors, hence prices behave differently. The rhythm of economic timings for each commodity is different. Investments play an instrumental role in each economic cycle," says Jim Steel, director of research at Refco Group Ltd. LLC in New York.

The length of a production cycle varies from sector to sector. Metals tends to have the longest production cycle, due to the lengthy and capital-intensive mining process. Being sensitive to economic cycles, metals are prone to experience a contraction in a sluggish economy because of lower demands for construction. Energy has the shortest cycle. Demand for both energy and metals tend to be cyclical. Energy products like gasoline and heating oil are also sensitive to weather conditions.

In contrast, production of agricultural products tends to be seasonal and demand is noncyclical. A high degree of government intervention in the agricultural sector very often includes heavy subsidies.

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