Get Balanced-Get Milk: Commodities Are a Great Way to Balance out Heavy Positions in Financials. but Just as Certain Financial Futures Can Be Correlated, So Can Many Commodity Markets. You Need to Consider Your Diversification within the Commodity Sector

Article excerpt

Portfolio managers, depending on the manager and type of investment firm, usually advise investors to allocate anywhere from 5% to 20% of their portfolios to commodities. The reason is simple: commodities provide diversification. Over time, diversification should improve returns and lower risk.

Diversifying among different commodities, each with its own supply and demand factors, may reduce the volatility of a portfolio and return it to safer risk levels. Unleveraged, commodities have historical volatility well below that of small-cap U.S. stocks and even stocks of emerging markets. Several other reasons exist in favor of diversification into commodities. First, commodities reduce exposure to inflation. Second, commodities have low correlations to stocks and bonds, so they're good diversifiers for traditional portfolios of financial securities.

While commodities carry risk, they are not intrinsically risky. Leverage is what makes them appear so, but the good thing about leverage is it's up to the investor how much to exploit it. The bottom line is that if an investment is made appropriately in a commodity, risk may be reduced.

Investors can gain exposure to commodities through a managed fund, an advisor-managed account or commodity related mutual funds. An avenue growing in popularity is broad-based commodity indexes, such as one of the five commodity indexes with exchange-listed contracts: the Goldman Sachs Commodity Index, the Dow Jones-AIG Commodity Index, the Rogers International Commodity Index, the Deutsche Bank Liquid Commodity Index and the Reuters/Jefferies Commodity Research Bureau Index.

Yet another approach is simply direct exposure to commodity vehicles, such as commodity futures. Indeed, this offers you the most flexible exposure to these markets. It allows you to take full advantage of the benefits of diversification because you can directly manage your positions within the commodity segment.

LIQUID EXPOSURE

Any mixture of commodities should not just seek to balance positions in financial or equity markets. The commodities themselves also should be uncorrelated to each other.

If the commodities are correlated, they will not be particularly useful for mainstream portfolio diversification. If there is high correlation between a potential market and the existing portfolio, then adding the new market will not help in diversifying the overall exposure. Of particular importance is the correlation to the financials because this would actually decrease the effectiveness of the commodity portion of the portfolio.

One problem diversified managers run into is a lack of capacity in liquid commodity markets to balance large allocations in financial markets. Most managers run out of commodities to trade before they reach the optimal mix.

One commodity that is particularly uncorrelated to most, and could solve this dilemma but is often overlooked, is milk. Milk futures are traded at the Chicago Mercantile Exchange. Class III milk futures, the most liquid contract in the complex, will help diversify the commodity section of a portfolio and potentially reduce overall portfolio risk (see "Spreading risk," left).

As shown in "Taking stock of milk" (right), S & P and Class III milk futures are not interrelated at a micro level, so diversification mitigates individual-sector risk. In other words, a slump in the economy might affect the S & P 500, but a lesser effect on Class III milk prices would allow the overall portfolio to weather the storm.

Overall, the nine markets shown in "Spreading risk" show weak correlation to the Class III milk market throughout the period 2000-05. This is good news for milk as a potential addition to the commodity portion of a portfolio, because it should not follow any trend exhibited in the markets that represents existing positions.

A common measurement of correlation is r-squared. …