The authors expand on earlier research that shows that adding commodity futures indexes to equity portfolios brings positive results in terms of risk and return because of the low or even negative correlation between the two asset classes. They demonstrate the benefits of adding individual commodity futures contracts to equity portfolios to enhance a portfolio’s risk–return trade-offs.
How Is This Research Useful to Practitioners?
Portfolio optimization and diversification are key issues for investment managers in achieving high returns at the lowest possible risk thresholds. The largest investment class has traditionally been equities, which are sensitive to interest rates. When interest rates rise in response to various factors—including inflation—bonds become an attractive alternative at their new higher yields, leading to pressure on equity prices to provide the targeted return to investors. Commodities have a positive correlation with inflation and thus provide a natural diversification tool for equity portfolios.
Over the past several years, the correlation between the commodities market and the equities market has increased as significant investment has been routed to commodities to hedge against both equity risk and inflation. The benefits of diversification are perceived to have decreased accordingly.
The authors reaffirm that significant benefits are still derived from this technique for portfolio diversification and optimization. Moreover, further benefits can be derived by adding an individual commodity futures contract to the equity portfolio rather than a commodity futures index, which has been the popular practice. According to the authors, such portfolios can also outperform equity-only portfolios.
How Did the Authors Conduct This Research?
The authors obtain daily futures prices from the Commodity Research Bureau (CRB) for all actively traded contracts in US markets over 1990–2012. They use 16 financial futures, including five equity index futures, four interest rate futures, and seven currency futures. The 21 commodity futures comprise three metals futures, four energy futures, six grain futures, five subtropical contracts (cocoa, coffee, sugar, orange juice, and cotton), and three livestock futures. The Goldman Sachs Commodity Index (GSCI) and the CRB Index, two futures contracts on commodity indexes, are also included. The authors construct the desired portfolios using a two-moment risk–return framework to identify the Markowitz mean–variance-optimal allocations of the futures contracts and then record their performances.
They demonstrate the value of a rebalancing strategy and the benefit to diversification, because individual commodity contracts have low correlations with each other as well as with equity and fixed-income assets. Most of the correlations across different types of commodities (grains versus energy) are between –0.25 and 0.18. For example, the portfolio is optimized using three months of daily data, followed by a three-month out-of-sample investment period. The out-of-sample optimized portfolios outperform not only an equal-weighted average of all contracts studied but also long-only equity indexes while reducing standard deviation and tail risk.
Abstractor’s Viewpoint
The search for alpha requires continuous effort on the part of investment managers to develop new strategies. A mean–variance-optimal portfolio will generally not outperform a 100% equity portfolio during times of stock market upturns. But over a market cycle, it can be expected to generate consistent returns and protect against downturns. The authors demonstrate the benefits of adding individual commodity futures contracts to equity portfolios: higher returns, lower volatility, and reduced chances of highly negative results.