Commodities asset allocation

IConsult

Whilst this isn't directly related to consulting, I assume a few readers may have more information than I and would be able to point me in the right direction.

Thanks in advance.

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I was recently given this scenario and would appreciate any advice as to how I would begin to approach and structure the answer.
Currently in a totally unrelated field, looking to make the move into asset management.

You're an analyst working with a family office. You're considering allocating 5% of the portfolio to commodities (current allocation is 0%), long-term view. You need to make the case for this to the fund manager.
What are the advantages/disadvantages you would have to consider?

Portfolio currently includes:
- Property
- Hedge Funds
- Fixed Income
- Private Equity
- Cash
- Equities

My first few thoughts were:
- The family office can tolerate moderate risk as they have exposure to hedge funds and private equity, which are riskier assets than F.I and property.

- Why diversification into commodities and why now?
- Which commodities?

I guess my first stumbling block was not knowing much about commodities or commodity indicies. Where would one go to find appropriate indicies that would help with this case? I was thinking of overlaying an MCSI/S&P chart with the S&P GSCI.

Any input would be great.

jon3001

Where do you get your homework from?

IConsult

Interview question with Watson Wyatt.

wombat42_2

For starters the most widely used coomodity index is the CRB index

http://www.marketwatch.com/quotes/crb

IConsult

Thanks wombat!

jon3001

IConsult wrote: »

You're an analyst working with a family office. You're considering allocating 5% of the portfolio to commodities (current allocation is 0%), long-term view. You need to make the case for this to the fund manager.

5% is probably too low and timid. Jim Rogers recommends 10%. Roger Gibson recommends up to 20% of the funds not allocated cash/fixed-interest (i.e. an 80/20 portfolio would have 16% in commodities) to benefit from maximum diversification.

IConsult wrote: »

What are the advantages/disadvantages you would have to consider?

Disadvantages: none for a growth portfolio. If it's an income portfolio then don't use commodities since they don't provide any income.
Advantages: better risk-adjusted portfolio returns.

IConsult wrote: »

Portfolio currently includes:
- Property
- Hedge Funds
- Fixed Income
- Private Equity
- Cash
- Equities

In what proportions? What is their time-horizon?

IConsult wrote: »

My first few thoughts were:
- The family office can tolerate moderate risk as they have exposure to hedge funds and private equity, which are riskier assets than F.I and property.

Sounds reasonable.

IConsult wrote: »

Why diversification into commodities and why now?

Commodities have low correlation with other asset clases. Commodity futures indexes and managed commodity pool funds have returns and volatility similar to other asset classes such as stocks.

Such diversification is good at any time of the day. They also act as an inflation hedge which might be relevant to today's economy.

IConsult wrote: »

Which commodities?

Diversified commodity investments will have exposure to all major commodities including: energy (oil/gas), precious metals, industrial metal, agriculture (inc softs), livestocks.

IConsult wrote: »

I guess my first stumbling block was not knowing much about commodities or commodity indicies. Where would one go to find appropriate indicies that would help with this case? I was thinking of overlaying an MCSI/S&P chart with the S&P GSCI.

Personally I don't like the S&P GSCI since it's extremely heavily weighted to one sector (oil). The DJ-AIGCI is more balanced. My favourite is the DJ-AIGC-F3 which maximises exposure to roll-yield, an important component of commodity future returns.

Commodity pools and managed funds can also go short to further reduce volatility.

IConsult

Jon, many thanks for this, it's been a great help.

jon3001 wrote: »

In what proportions? What is their time-horizon?

Unfortunately, I didn't don't have this information to hand. I think the point there were trying to make is that the portfolio is already diversified to some extent.

jon3001 wrote: »

Diversified commodity investments ....

Do you mean commodity futures indexes and managed funds?


Once again, many thanks for the help.

jon3001

IConsult wrote: »

Do you mean commodity futures indexes and managed funds?

Yes. Investable indexes and managed funds of commodity futures.

Wealthy private investors might be get access to commodity pools or managed futures accounts. A retail investor would be looking at a managed fund which uses ETFs to go long/short (e.g. Marlborough ETF Commodity Fund)

jon3001

jon3001 wrote: »

Disadvantages: none for a growth portfolio.

Well - one disadvantage for highly diversified portfolios is something called the tracking error. But really it can be just psychological.

If the FTSE is doing really well it may outperform the diversified portfolio and investor might wish they weren't diversified. Of course the diversified portfolio shows its strength when the FTSE is doing poorly. Some investors expect their returns to broadly follow the FTSE but highly diversified portfolios might have a radically different pattern of returns and undertrack for years.

Given that the original portfolio was already using alternative asset classes (hedge funds, private equity) then this shouldn't be an issue.