Commodities in a Traditional Investment Portfolio

1. Commodities in a Traditional Investment Portfolio Timothy J. Rudderow Friday, 4 March 2005

2. Commodities are HOT • Search for non-correlated return • Adding commodities to investment portfolios has gained traction • Accessible commodity index products have simplified the analysis

3. Question #1 • “In each of the other asset classes in my portfolio, I understand the economic risk premium I earn when I make the investment. It helps me form ideas about expected return and risk.” • What is the economic risk premium in a commodities investment?

4. Question #2 • “If I add a commodities investment to my portfolio, what is the impact?” • Can I make a difference? • Leverage? • Does the volatility help or hurt the portfolio? • Will I lose my job?

5. Risk Premium: Motivation Past performance is not necessarily indicative of future results.

6. Risk Premium • Risk Premium arguments look to the futures markets • Futures markets exist to allow commercial interests to reduce price and rate risk • Logical that the eventual holder of that risk earns a risk premium • Challenge is in the measurement – an Index • Must be passive and price based • Must be able to replicate in the market

7. Hedging Today Global Bonds $$ CHINA Products $$ $$ Raw Materials

8. Risk Premium: Method #1 • Keynes: Normal Backwardation • Futures trade at a discount to spot to compensate the risk bearer • Son of Keynes: Goldman Sachs Commodity Index • Younger Sibling: DJAIG Commodity Index • Index construction • Long a basket of commodity futures • Market weights based on production

9. Method #1 • Components of return • Change in the price of the spot commodity • Normal backwardation premium (or discount) in the futures price • Risk Free interest rate • Most bang in rising commodity environments • Best in non-storable markets

10. Method #2 • Background • My bias: Full disclosure • “What is the Benchmark?” • Market Realities • Hedgers on both sides of the markets • Specs are long and short, too • Volatility represents risk to business interests • Back to the wheat chart

11. MLM Index™ Construction • Recently “modernized” • 22 futures markets • Volatility Weighted Baskets • Unleveraged • Rebalanced monthly • Positions can be long or short • Transparent

12. Method #2 • Components of return • Gains from long and short positions • Risk free rate of interest • Performance • Does well in sharply rising or falling markets • Does poorly when markets are in equilibrium • Broadens the risk premium argument to the full range of markets – all futures

13. Side Thought: Alpha and Beta Sources: CTA is the CSIDM/MAR CTA Index, Jan-92 thru Dec-04 (www.marhedge.com) CSFB is the CSFB Managed Futures Index , Jan-94 thru Dec-04 (www.hedgeindex.com) MLM is the simulated modernized MLM Index™ Past performance is not necessarily indicative of future results.

14. Return Summary Past performance is not necessarily indicative of future results.

15. Relationship with other Assets Past performance is not necessarily indicative of future results.

16. Why a Risk Premium? • Inelasticity of the underlying markets • Makes commercial markets different than equity markets • It’s the reason businesses hedge • Competition for capital • Without a risk premium, futures markets become a casino – no reason to play • Premium should be competitive with other capital markets.

17. Question #2: Portfolio Impact • The Holy Grail • Positive return • Mark to Market • An measurable economic risk premium • No correlation with traditional assets • COMMODITIES

18. Motivation: Volatility is Your Friend Past performance is not necessarily indicative of future results.

19. Asset Class Returns Past performance is not necessarily indicative of future results.

20. Asset Class Returns Past performance is not necessarily indicative of future results.

21. Effects on Efficient Frontier by Adding Futures to a Mix of Stocks and Bonds 20% Compound Annual Return Large & Small Caps, LT Govt, LT Corp & Junk 18% 16% 8% Large Cap 20% Large Cap 8% Small Cap 20% Small Cap 8% LT Govt 20% LT Govt 14% 8% Junk Bonds 50% Large Cap 20% Junk Bonds 8% LT Corp 50% Small Cap 20% LT Corp 60% MLM 1X 0% LT Govt 0% Junk Bonds 0% LT Corp 12% 0% Large Cap 0% Large Cap 10% 0% Small Cap 0% Small Cap 0% Large Cap 0% LT Govt 0% LT Govt 0% Small Cap 0% Junk Bonds 0% Junk Bonds 33.3% LT Govt 0% LT Corp 0% LT Corp 33.3% Junk Bonds 100% MLM 1X 100% GSCI 33.3% LT Corp 8% 4% 6% 8% 10% 12% 14% 16% 18% 20% 22% Period Jan 1980 - Dec 2004 Standard Deviation Baseline Portfolio Past performance is not necessarily indicative of future results.

22. Effects on Efficient Frontier by Adding Futures to a Mix of Stocks and Bonds 20% Large & Small Caps, LT Govt, LT Corp & Junk Compound Annual Return With GSCI 18% 16% 8% Large Cap 20% Large Cap 8% Small Cap 20% Small Cap 8% LT Govt 20% LT Govt 14% 8% Junk Bonds 50% Large Cap 20% Junk Bonds 8% LT Corp 50% Small Cap 20% LT Corp 60% MLM 1X 0% LT Govt 0% Junk Bonds 0% LT Corp 12% 0% Large Cap 0% Large Cap 10% 0% Small Cap 0% Small Cap 0% Large Cap 0% LT Govt 0% LT Govt 0% Small Cap 0% Junk Bonds 0% Junk Bonds 33.3% LT Govt 0% LT Corp 0% LT Corp 33.3% Junk Bonds 100% MLM 1X 100% GSCI 33.3% LT Corp 8% 4% 6% 8% 10% 12% 14% 16% 18% 20% 22% Period Jan 1980 - Dec 2004 Standard Deviation Adding GSCI Past performance is not necessarily indicative of future results.

23. Effects on Efficient Frontier by Adding Futures to a Mix of Stocks and Bonds 20% Large & Small Caps, LT Govt, LT Corp & Junk Compound Annual Return With GSCI With MLM 18% 16% 8% Large Cap 20% Large Cap 8% Small Cap 20% Small Cap 8% LT Govt 20% LT Govt 14% 8% Junk Bonds 50% Large Cap 20% Junk Bonds 8% LT Corp 50% Small Cap 20% LT Corp 60% MLM 1X 0% LT Govt 0% Junk Bonds 0% LT Corp 12% 0% Large Cap 0% Large Cap 10% 0% Small Cap 0% Small Cap 0% Large Cap 0% LT Govt 0% LT Govt 0% Small Cap 0% Junk Bonds 0% Junk Bonds 33.3% LT Govt 0% LT Corp 0% LT Corp 33.3% Junk Bonds 100% MLM 1X 100% GSCI 33.3% LT Corp 8% 4% 6% 8% 10% 12% 14% 16% 18% 20% 22% Period Jan 1980 - Dec 2004 Standard Deviation Adding MLM Index™ Past performance is not necessarily indicative of future results.

24. Effects on Efficient Frontier by Adding Futures to a Mix of Stocks and Bonds 20% Large & Small Caps, LT Govt, LT Corp & Junk Compound Annual Return With GSCI With MLM With MLM 3X 18% 16% Large Cap 0% Large Cap 16% Small Cap 0% Small Cap 16% LT Govt 0% LT Govt 16% Junk Bonds 0% Junk Bonds 16% LT Corp 0% LT Corp 20% MLM 3X 16% 100% MLM 3X 8% Large Cap 20% Large Cap 8% Small Cap 20% Small Cap 8% LT Govt 20% LT Govt 14% 8% Junk Bonds 50% Large Cap 20% Junk Bonds 8% LT Corp 50% Small Cap 20% LT Corp 60% MLM 1X 0% LT Govt 0% Junk Bonds 0% LT Corp 12% 0% Large Cap 0% Large Cap 10% 0% Small Cap 0% Small Cap 0% Large Cap 0% LT Govt 0% LT Govt 0% Small Cap 0% Junk Bonds 0% Junk Bonds 33.3% LT Govt 0% LT Corp 0% LT Corp 33.3% Junk Bonds 100% MLM 1X 100% GSCI 33.3% LT Corp 8% 4% 6% 8% 10% 12% 14% 16% 18% 20% 22% Period Jan 1980 - Dec 2004 Standard Deviation Adding Leverage Past performance is not necessarily indicative of future results.