Monday, September 18, 2006

More on Commodity Allocations

PIMCO recently commissioned a study by Ibbotson Associates regarding the use of commodities in Strategic Asset Allocations. The study provides indepedent confirmation of our own research into the use of commodities in our portfolios. The study is available through PIMCO's web site, but it is quite technical and is probably only suited for the true investment geeks among us. Here are some highlights:

This paper studies the role of commodities in a strategic asset allocation. Commodities are real return, real assets that are part of the consumable/transformable super asset class and the storeof-value super asset class. There are several methods of obtaining exposure to commodities. This paper focuses on the type of exposure to commodities produced by a fully collateralized total
return commodity index.

Using historical capital market assumptions based on annual data from 1970 to 2004, we found that including commodities in the opportunity set resulted in a superior historical efficient frontier, which included large allocations to commodities. Over the common standard deviation range, the average improvement in historical return at each of the risk levels was approximately 133 basis points.

No matter which set of returns was used, including commodities in the opportunity set improved the risk-return characteristics of the efficient frontier. Furthermore, commodities played an important and significant role in the strategic asset allocations. Given the inherent return of commodities, there seems to be little risk that commodities will dramatically underperform the other asset classes on a risk-adjusted basis over any reasonably long time period. If anything, the risk is that commodities will continue to produce equity-like returns, in which case, the forwardlooking strategic allocations to commodities are too low.

Most strategic asset allocations consist primarily of allocations to the three “traditional” asset classes—stocks, bonds, and cash. Expanding the investable universe beyond these three traditional asset classes improves the risk-return characteristics of a strategic asset allocation. Asset classes with low correlations to the current opportunity set of asset classes provide the largest benefit.

In the last paragraph above, notice the phrase "Asset classes with low correlations to the current opportunity set of asset classes provide the largest benefit". At AIM we include Commodities and REITs in all our portfolios for exactly this reason. Both REITs and Commodities have low correlations to the traditional asset classes of stocks, bonds and cash. We believe using these assets in our portfolios will produce, over time, higher returns and lower volatility for our clients. Click on the title of this post to read an interview with PIMCO SVP Bob Greer. Full disclosure: AIM sometimes uses PIMCO funds in our allocations, specifically the PIMCO Commodity Real Return Fund.

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