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By Paul Justice, CFA | 09-22-2011 05:06 PM

Getting the Most From Commodity Investments

Limiting implicit storage costs can help boost returns from commodity futures investments, says Yale professor Geert Rouwenhorst.

Paul Justice: Hi. I'm Paul Justice, director of exchange-traded fund research in North America from Morningstar. I'm coming to you live from the ETF Invest Conference in Chicago. Today, I have the pleasure of being joined by Geert Rouwenhorst, Yale professor and originator of one of our favorite commodity funds in the market today, the United States Commodity Index ETF, ticker USCI. Geert thank you so much for joining me.

K. Geert Rouwenhorst: Thanks, Paul, for having me.

Justice: So much of your research has been influential on the way that people approach the commodities' market. Your paper back in 2004 with Gary Gorton was really influential in driving people to the asset-allocation and total-return benefits of commodities. Could you talk a little bit about that research and where you identified sources of returns for commodity markets?

Rouwenhorst: Right. So prior to the paper, Gary and I asked a question, what do we actually know about the merits of going passively long in commodity futures? And the problem was there was no good data available to analyze the returns on those investments. Typically, we have very good data on stocks and bonds. We had none on commodities. So the simple thing we try to do is put together a long time series going back to 1960 and analyze the performance of this asset class.

Surprisingly, you know a commodity index consists typically of two things. It's a collateral return, typically T-bills or some fixed-income instrument, and then that's overlaid by a long position in futures. And people ask, is there any return that you can get from the futures component of that portfolio? And it turned out that during that 50-year-period that we looked at, there risk premium that you would get from the futures component was about 5% annualized, which is actually the same risk premium that people generally associate with in investing in the stock market. So it was quite a big surprise.

Justice: Yeah. The great thing about that was you're getting a return that was both positive on a real adjusted basis and had a very low correlation with the other asset classes that you had in the portfolio.

Rouwenhorst: Right. So that is one of the things that made it of course very attractive for large institutional portfolios because it was a means to diversify sort of the traditional asset classes such as stocks and bonds. Now, more recently what we've seen is that while the correlations between commodities and bonds have remained stable and low, pretty close to zero, the commodity correlations with equities have actually been creeping up relative to the long-term average that we have been documenting in our research.

There could be two reasons for that. We've been going through a time of crises somewhat, and if you look back historically, correlations have been higher during previous crises as well. Another explanation may have to do with the fact that there's more interest in this asset class, and people trade in and out into commodities in the same way as they do in the equity markets based on the risk appetite of the moment.

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