This Month's Letter to the Editor: Weighting of Commodities in Model Portfolios

I have a nagging question: How can one justify such a large weighting (10%) of commodities in your model portfolios? Over the longer run (50-100 years), it seems most commodities stay fairly stable in price or drop in value.

Thank you for an excellent question. We agree with the general thrust of your argument about the questionable wisdom of holding physical commodities. However, your question makes clear to us that we should more clearly specify that our allocation to commodities is based on an investment in commodities futures. Both of the commodity index funds available to investors today -- the Oppenheimer Real Assets Fund and the PIMCO Commodities Real Return Strategy Fund -- track indexes that are based on commodities futures (respectively, the Goldman Sachs Commodities Index and the Dow-Jones AIG Commodities Index). As described in the paper "Fact and Fantasies About Commodity Futures" by Gorton and Rouwenhorst (available on www.ssrn.com), the source of return from investing in commodities futures comes not from changes in the price of the commodities themselves, but from providing insurance against unexpected price changes. Given this, it is possible to earn positive returns from commodity futures even as the price of the underlying commodities is declining. The authors also found that the premium (above government bonds) for investing in commodities between July, 1959 and March, 2004 was about 3.5%, which approximately matched the premium on equities. More important was the authors' finding that over the period studied, commodity futures returns were negatively correlated with the returns on both U.S. equities and U.S. government bonds.

In addition, with respect to your point about long-term commodities price trends, a study by the International Monetary Fund ("The Long-Run Behavior of Commodity Prices" by Cashin and McDermott, available at www.imf.org) looked at real price trends between 1862 and 1999. The authors found a downward trend of about one percent per year over this period. However, this was also accompanied by rising price volatility. The authors conclude that "the downward price trend is of little practical relevance, since it is small and completely dominated by the [rising] variability of prices." In sum, it is the underlying volatility of commodity prices, rather than their level, that is the fundamental source of the returns from investing in commodity futures.

| This Month's Issue: Key Points | This Month's Letter to the Editor: Weighting of Commodities in Model Portfolios | Global Asset Class Returns | Equity Market Valuation Update | DFA versus Vanguard: The All-Stars Compared | Model Portfolio Update | Product and Strategy Notes: Gold ETF, ETF Tracking Error, Hussman Funds and Economic Indicators Update |