Commodities and Financial Insecurities

In 2006, oil economics have dominated financial headlines. Early in July, oil hit an all-time high price of $79 per barrel, putting a damper on summer vacation travel as gasoline spiked above $3 per gallon. As oil prices soared and inflation increased, Americans felt less financially secure.

Then, as swiftly as oil prices had increased, they reversed. Within three months, the cost per barrel fell by a third. Americans breathed a collective sigh of relief as they pumped cheaper gas and anticipated lower home heating bills. As inflationary pressure eased, financial security returned.

This drama demonstrated two important points:

• Commodities have become important drivers of economic trends with direct impact on pocketbooks, inflation and long-term planning – especially for retirees living on fixed incomes.
• Commodities are very volatile, and their price swings can influence stocks in the opposite direction. Sharply rising oil prices helped to produce the early summer stock market swoon. When oil prices fell, the stock market rallied.

Amid this drama, a related development went unnoticed by most investors and advisors. In April, for the first time, investors gained access to buying and selling "virtual barrels of oil" in brokerage accounts and self-directed IRAs. This occurred with the listing of the United States Oil Fund (USO) ETF on the Amex. USO is designed to track the price of one barrel of crude oil by investing in a mix of futures contracts, options and forward contracts. With an expense ratio of 50 basis points, it is an economical way to buy and sell physical oil (the commodity) without the complexities of futures trading. In a short period of time, USO attracted assets under management exceeding $500 million.

USO was the second commodity-based ETF in the U.S. to break new ground in 2006. The first to gain regulatory clearance for investing in futures contracts was the DB Commodity Index Tracking Fund (DBC), launched in February. (In June, it came under the sponsorship of PowerShares.)

DBC tracks the Deutsche Bank Liquid Commodity Index (Optimum Yield) and uses a rules-based formula to replace expiring futures contracts with new contracts having the highest "implied roll yield." As of October 24, the portfolio consisted of the following futures contracts in the following portfolio weights:

With broader diversification among commodity types than USO, DBC is a better vehicle for implementing a broad commodity asset class into asset allocation programs. According to the fund's manager, DB Commodity Services, LLC, the index tracked by this ETF produced a 10-year annualized return of 15.7%, as of June 30th, 2006.

Other Developments in Commodities ETFs

If you define commodities as natural resources or agricultural products, they include oil and gas, precious and industrial metals, grain and livestock, timber and water. Through stocks and mutual funds, there are many ways to invest in companies that exploit commodities. However, these are not "pure commodity plays" because they are influenced by the stock market's direction, company management decisions, and quarterly earnings – in addition to commodity price trends. Adding a true "commodity asset class" means giving investors exposure to price changes in physical assets, which trade in their own spot and futures markets apart from the stock market. In the past two years, ETFs have emerged as the most effective way to provide this exposure for individual investors.

The first ETF to invest directly in commodities was streetTracks Gold Shares (GLD), launched in November 2004. With more than $7 billion in assets under management, it has cracked the list of the top 10 ETFs in the U.S. (ranked by assets). Designed to track the price of one-tenth of an ounce of gold, GLD physically owns more than 12 million ounces of gold. Its gold purchases ? which Barron's believes absorbed 5% of total global gold demand in 2005 and 2006 ? had a direct influence on gold's price run-up.

In April 2006, iShares launched a comparable ETF for direct ownership of silver, the iShares Silver Trust (SLV). However, the launch occurred just before a global decline in commodities prices, and SLV has not yet equaled the success of GLD. The major U.S. ETFs that offer exposure to commodities are summarized in the table below.

* Unlike the other ETFs in this list, PHO invests in water resource companies, not physical commodities or futures contracts. It is included for reasons discussed elsewhere in the article.

Commodities: Why and How?

The "emerging markets" story that makes commodities attractive is as follows: Over the next few decades, perhaps as many as one billion people now living in underdeveloped nations (especially China and India) will rise from poverty to middle-class. Their consumption, combined with the industrialization of emerging markets, will put huge pressure on the globe's available resources, driving commodities prices higher over time. This story contributed to a run-up in commodity prices that began in 2001 and continued through mid-2006.

The world's most widely quoted commodities indexes are published by Commodity Research Bureau (CRB). For background on CRB indices, you can download a useful Excel file here:

• http://www.crbtrader.com/crbindex (Click on "Monthy Charts and Data.")

The oldest and most comprehensive of these indices is the Reuters/Jeffrey CRB Total Return Index (CRB), which includes 19 commodities. About 39% of its weighting is in oil & gas, 20% in metals, and 41% in agricultural products. From a cyclical bottom in October 2001, the index rallied through August of 2006, producing an annualized total return of 33.5% over this period. In duration and strength, it mirrored similar rallies in the index that occurred from 1986 to 1991 and from 1993 to 1998. The copyrighted chart below, which is updated on the CRB Web site, shows the long-term price cycles in the CRB since 1982.

From the CRB's peak on August 9 through September 20, the index declined by 14.5%. A rival commodities index more heavily weighted in oil and gas, GSCI Total Return, declined by 20.2% from top to bottom over the same period.

Benefits of Commodities in Asset Allocation Programs

In addition to their total return potential during up cycles, commodities are attractive in asset allocation programs for two other reasons:

1. Inflation hedging – Since 1982, monthly changes in the CRB have correlated at +0.92 with monthly changes in the Consumer Price Index. This suggests that broadly-based commodity benchmarks are the best pure inflation hedge available to most investors.
2. Low correlation with stocks and bonds – Several studies have shown that broadly-based commodities indexes have a correlation with U.S. stocks that ranges from about zero to -.20. The correlation with U.S. Treasury bonds ranges from zero to +0.30. The oil and gas components of the CRB have averaged a negative correlation with U.S. stocks of -0.24 over the past decade, according to CRB analysis.

The Value of Strategic Adjustments

The key to including commodities effectively in asset allocation programs is to begin with two basic beliefs:

1. They are very volatile.
2. No investor must have them.

To achieve long-term financial goals, almost all investors need exposure to stocks and bonds. But commodities should be considered an optional, opportunistic asset class, to be added when prices seem favorable relative to historical cycles. In other words, allocations to commodities should be strategically adjusted ? perhaps from 20% of total portfolio weight down to 0% – based on price trends and cyclical opportunities.

While the commodity price decline of August/September 2006 seems significant now, it is not yet of the magnitude of historic cyclical downturns, indicating that commodities may still be somewhat risky at current levels.

Here is how an asset allocation program that includes commodities could be explained to investors by a financial adviser: "I believe in including commodities as an asset class because they can have attractive return characteristics at times, and they help to balance stocks and bonds while offsetting inflation. But they are volatile and prone to sharp price declines at other times. We should consider putting 5% of your portfolio in oil if it goes as low as $45 per barrel. If it goes lower, we may increase that weighting. But we would then look to sell this allocation if oil prices then rise to the $60 to $70 level."

When any one asset class in an allocation program is strategically re-allocated, the other classes must be re-allocated in accommodation. Therefore, adding commodities to a program can require a switch of the allocation platform from "auto-pilot" to a more flexible model. An auto-pilot allocation model is defined as one in which asset class guidelines almost never change, and the only periodic changes are via mechanical automatic rebalancing. Auto-pilot made sense in the 1990s because computer systems of that era were not sophisticated enough to track and re-allocate large numbers of asset allocation accounts. But today's computers can be programmed to make re-allocation changes fairly quickly across large numbers of similarly managed accounts.

Enriched and strategically re-allocated asset allocation programs are the wave of the future. By adding cyclical asset classes (e.g., commodities, currencies, emerging markets and real estate), they give investors the opportunity to participate in powerful trends of continuing duration. By dynamically re-allocating portfolios as cycles shift, they give financial advisors a meaningful role in watching the markets and seeking to enhance risk-adjusted returns.

In today's markets, it should be obvious to financial advisors that strategic re-allocations in asset class guidelines, based on broad shifts in economic and market cycles, can produce positive results. For example, bonds were a less attractive investment in 2004-05, when the Fed was consistently raising interest rates, than in 2006, when rate-hiking pressures moderated. Yet, most auto-pilot programs hold the same bond exposure consistently across a full Fed rate cycle.

Enriching asset allocation programs with the addition of classes such as commodities and real estate requires strategic re-allocation, because these classes are so cyclical and volatile. Adding these classes will enable you to demonstrate to wealthy investors your role in monitoring cycles and making re-allocation recommendations periodically. In turn, this will increase the fees that you can earn on assets under management.

Specific Suggestions for Implementing Commodities into Asset Allocation Programs

• Of the ETFs already on the market, two are attractive for gaining broad exposure across commodities. Emphasize GSC for more oil exposure and DBC for less oil exposure.
• Because oil has direct impact on consumers, you may want to add exposure to USO for clients who are worried about higher inflation, especially retirees living on fixed incomes. USO also should have a lower correlation with stocks than more broadly based ETFs such as GSC or DBC.

• Among the precious metals, the "emerging markets" story applies more to silver than gold, because silver is an industrial metal widely used in making batteries and electrical components, in addition to jewelry. Also, China is expected to exhaust its silver surplus and become a net importer in the decade ahead.

(Note: Silver has not yet experienced increased demand due to heavy asset flows into ETFs. Some sources believe that if silver ETFs attract a fraction of the assets now held in gold ETFs, the increased demand will put huge pressure on global silver prices.)

A growing number of other U.S. ETFs hold stocks of commodities-supplying companies, and could be included in a commodities asset class. They are listed in the table below.

The Future of Asset Allocation

Wealthy clients are being attracted to hedge funds mainly because of the potential to profit from non-correlating asset classes and strategies. The new wave of asset allocation programs will offer the same advantages with lower costs, more service and far greater transparency, as shown below.

Summary

In retail investing, the mutual funds industry was responsible for taking asset allocation programs mainstream in the early 1990s. Plain-vanilla, auto-pilot mutual fund programs made asset allocation easy to understand and simple to manage. But times change and today's investors want more, especially at the top of the wealth market.

In the competition between ETFs and mutual funds for wallet share, ETFs have pulled a coup by taking command of new asset classes such as commodities, currencies, individual emerging markets and private equity.

The premier asset allocation programs of the future will be delivered through brokerage accounts, self-directed retirement plan options, and self-directed IRAs. They will include mutual funds, ETFs, stocks and bonds. They will be enriched with new asset classes and guided by financial advisers who make periodic strategic re-allocations in asset class guidelines.

For tax management reasons, retirement plans will be the best place to implement these programs. Commodities exposure will be important in such programs for increasing the inflation protection of retirement assets.

When you add commodities to asset allocation programs through ETFs, you will force your practice to move into the future.