This article appeared in Finance Magazine

Commodities’ role in an investment portfolio
Commodities played a starring role in the recent strong performance of the National Pension Reserve Fund (NPRF), with the fund’s €170 million allocation to commodities, returning almost 36 per cent, over the course of the year. The NPRF accessed the commodities market through the Goldman Sachs Commodity Index (GSCI), which has become the premier global commodity benchmark. Paul Callan explains how the GSCI is structured, and the role commodities should play in investors’ portfolios.
Institutional investors are increasingly making portfolio allocations towards commodities. Crude oil’s 40 per cent increase last year grabbed headlines, but other commodities rose strongly as well. Indeed, the Goldman Sachs Commodity Total Return index rose 44.4 per cent in euro term in 2005. But the appeal of commodities goes far beyond their recent high returns.

The Goldman Sachs Commodity Index was created in 1991, but has data stretching back to 1970. The index was designed to provide a reliable and publicly available benchmark for commodities. The index is weighted by world- production this is a similar approach to market capitalisation weighted equity indices. Since its launch, the GSCI has become the premier global commodity benchmark.

The GSCI has historically had high equity‑like returns albeit with higher volatility (see Table 1). Such high returns would make an allocation to Commodities attractive from a stand-alone view point. But perhaps more importantly returns are generally uncorrelated with stocks and bonds. Commodities are particularly attractive in the context of a portfolio combining different asset classes.

Because returns are generally uncorrelated to both bonds and equities an allocation to commodities can further diversify a portfolio while improving portfolio efficiency. The resultant portfolio has higher returns and lower volatility clearly this is a very attractive attribute for investors.

Commodities have performed best when equities have performed worst, significantly outperforming when a portfolio needs diversification most. Goldman Sachs reviewed returns from a typical 60/40 per cent balanced portfolio and plotted returns for other assets during those same periods (see Table 2). As can be seen the returns have been very positive at 16.9 per cent versus a World Equity decline of almost 20 per cent. In some crisis events, especially when there are supply worries like the Gulf Wars, bond and equities normally fall together while commodities prices often rise.

Over the last number of years financial markets have placed a lot of store in the inflation fighting credentials of global Central Banks. Because of this and other global developments financial assets and bonds in particular are priced for inflation to stay low. Bond yields are close to generational lows. If for whatever reason inflation were to reappears other things being equal financial assets prices would likely adjust downwards in real terms. Commodities have proven to be positively correlated with both producer and consumer prices and should act as an inflation hedge.

Strong economic growth over the last number of years has caused a substantial increase in the demand for commodities. Emerging economies like China and India are expected to grow rapidly for many years; at this stage of their economic development they are likely to continue to be heavy consumers of commodities.
A lack of capital spending in the 1990s has resulted in severe supply constraint in many commodity sectors. Under investment has impacted production processing refining transportation and storage. Developed world production is falling for most commodities. This reliance on less stable regions increases the risk of product price spikes as well as increasing the overall cost because of transportation and storage charges etc.
Despite elevated prices current OPEC production is nearly the same as in 1980. Global rig counts are far below the peak in 1981.Tanker capacity peaked in the late 1970s while oil refining capacity peaked in 1981. The supply demand situation has resulted in low and falling inventories of crude oil.

The dominant sector weight in the GSCI is energy accounting for 76 per cent of the index. Agriculture and industrial metals account for 10 per cent and 7 per cent respectively. Copper inventories are very low and aluminium stocks levels are falling rapidly. Global inventories of both wheat and corn remain at low levels.
The GSCI invests in 24 commodities which provides a high level of diversification within commodities but as noted the energy related sectors has a heavy weight. While most commodities are priced in US dollars Eagle Star’s new fund allows Irish investors easy access to commodities attractive investment characteristics and it is priced in Euros as part of the Matrix range.

In summary, commodities can add important benefits to an investor’s portfolio. New market instruments, such as exchange traded funds allow easy access to the returns from commodity investing. Eagle Star has recently launched a fund based on the GSCI Total Return Index. This fund is available as part of Eagle Star’s Matrix range of funds.
Paul Callan is an associate Director, investment dealing, in Eagle Star Life.
This article appeared in the April 2006 edition of Finance Magazine.