Standard & Poor's Mike McGlone says the development of the company's commodities index has helped the asset class grow in popularity.
The development of the S&P GSCI has opened up the area of commodity indices, enabling the asset class to become an increasingly popular part of investment strategies.
Ranging in type from oil and gold to wheat and livestock, commodities cover some of the oldest forms of assets and have long been recognised as a useful portfolio diversification tool. Until the advent of commodity indexing, however, this was not an easy area for investors to gain effective exposure to. The development of commodity indices such as the S&P GSCI has opened this area up, with commodities becoming an increasingly popular part of investment strategies.
The first decade of the millennium marked an advance in commodity indexing from a second tier asset class to a primary part of the traditional stocks, bonds and cash portfolio mix. Over this period, commodities have demonstrated an ability to improve portfolio returns and reduce overall risk as part of an augmented approach to asset allocation.
The S&P GSCI was created in 1991 and was essentially the first truly investable commodity index. Prior to the S&P GSCI, the best choice for investors seeking commodity exposure was commodity-based equities. Unfortunately, most commodity-based equities have historically demonstrated a higher beta (or correlation) to the S&P 500 than to commodities. Adding exposure to such equities to an existing equity-based portfolio therefore does little to augment diversification.
From a longer-term investment portfolio standpoint, equities have their place, but so do commodities – a key difference being the insurance factor. If most commodities were to increase rapidly, this may create an adverse impact on many people as well as the wider economy. Thus some proportional portfolio investment exposure to commodities can act as a diversifying insurance factor. Commodities entail risk, volatility and periods of underperformance, but they also provide event/risk protection. When the traditional approach to asset allocation is augmented, commodities have demonstrated, in the past and during the most recent decade, a general improvement in portfolio returns and reduced overall risk.
An up but volatile decade: future lessons
As the most widely followed commodities benchmark, the performance of the S&P GSCI over the noughties provides interesting insights into the benefits of and issues surrounding commodities investing during the decade and lessons for the future.
The S&P GSCI ended the decade with a cumulative total return of +63.69% on the back of a 13.48% gain in 2009. Over the same period, a 23.57% decline in the US Dollar Index boosted US dollar-based assets with the notable exception of the S&P 500, which declined 9.10% for the decade. The cost advantage of holding non-income-producing physical assets, like the S&P GSCI, was certainly enhanced during the decade as the US Government benchmark two-year note declined from a yield of 6.21% at the end of 1999 to 1.14% at the end of December 2009.
While the performance of commodity investing as demonstrated by the S&P GSCI was impressive overall, the recent decade experienced one of the most significant boom and bust cycles in commodity indexing history (graph 2).
Despite the migration towards higher correlations among asset classes resulting from the 2008 global economic crisis, the S&P GSCI ended 2009 about where it ended in 2003 and generally demonstrated a history of equity-like returns, but with a low correlation to the S&P 500 and many other asset classes (graph 2).
The decade was also notable for one of the most severe commodity corrections in history: at its peak in June of 2008, the S&P GSCI was up 281% from the end of 1999 until the global economic crisis took hold. From the June 2008 peak to the index’s low in February of 2009, the S&P GSCI suffered a historic 68% decline, the biggest in the index’s 1970 backdated history.
From the February 2009 low until the end of December, the S&P GSCI recovered 33.72%. It took the first global recession since WWII and the worst year for the S&P 500 price return since 1931 for the major asset class correlations to gravitate towards one.
Diversification improved returns
The last decade has, however, demonstrated using commodities as part of a diversified portfolio improves overall returns. Despite the substantial coordinated plunge in most major asset classes experienced in 2008, a combined portfolio including an 80% allocation to the S&P 500 and 20% allocation to the S&P GSCI (and rebalanced annually) had a higher return and lower standard deviation than the S&P 500. The S&P 500/GSCI portfolio had a decade total return of +9.61% with a standard deviation of 14.69%, compared to the negative 9.10% total return for the S&P 500 with a standard deviation of 16.13% over the same time period (graph 2).
Historic contango condition
One aspect of commodities investing that cannot be forgotten is the effect of contango. Contango exists when further-out future contracts trade at higher prices, thus reducing total returns on indices reflecting commodity investments that periodically roll futures contracts. The end of the past decade was a reminder to investors commodity investing involves more than just exposure to changes in the spot price. Related to the global economic crisis, extreme contango conditions developed in many commodity futures curves late in 2008 and early 2009.
Graph 3 depicts the percentage spread between the first and second crude oil futures. Reflecting the extreme contango situation, this spread reached the highest level in crude oil futures history in December of 2008. Such extreme contango or backwardation conditions have demonstrated a history of mean reversion.
The S&P GSCI family includes indices designed to alleviate the potential negative impact of contango on total returns. These include the S&P GSCI Enhanced Index and Forward series of indices and the S&P GSCI Crude Oil Covered Call Index. For the decade, the S&P GSCI Enhanced Index increased 272.50% and the S&P GSCI three-month Forward Index increased 287.36% on a backdated basis.
Commodities investing matured over the first decade of the 21st century to become a primary part of the traditional portfolio mix. Despite the effects of the global recession, it has proved itself an effective strategy for improving portfolio returns and reducing overall risk. As the pressure on fund managers to demonstrate effective asset allocation strategies becomes ever stronger, the diversification benefits of commodities will become ever more important through the next decade and beyond.
Mike McGlone is senior director of commodity indices at Standard & Poor’s
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