Commodities have long been stereotyped as an exceptionally volatile investment, but in the past five years at least, this has not been true of all of the mutual funds and ETFs that are categorized as broad-basket commodity funds. In fact, some funds would have made a very positive return to a typical portfolio with relatively low volatility.

As defined by Morningstar, "broad-basket commodity portfolios can invest in a diversified basket of commodity goods, including but not limited to grains, minerals, metals, livestock, cotton, oils, sugar, coffee and cocoa. Investment can be made directly in physical assets or commodity-linked derivative instruments, such as commodity swap agreements."

Some commodity funds invest only in a specific kind of commodity, like agriculture, energy, industrial metals or precious metals. Further, some funds may focus on only one specific commodity, like gold or copper.



As of May 31, there were 44 distinct mutual funds classified by Morningstar as broad-basket commodity funds. Of that total, only 10 funds had a five-year performance history as of Dec. 31, 2011 (as shown in the Broad-Basket Commodity Funds chart below). Commodity funds that used leverage were excluded.

The five-year average annualized performance for these 10 broad-basket commodity funds ranged from -6.86% to 2.6%. Three of the commodity funds (SKNRX, PCRIX and DBC) had a better five-year performance than the S&P 500 (as represented by the Vanguard 500 Index, VFINX).

The five-year standard deviation of annual returns for four of the commodity funds (CRSOX, CCRSX, DJP and DBC) was essentially identical to that of the S&P 500. While commodity funds are perceived as significantly more volatile than stock mutual funds, over the past five years the S&P 500 was as volatile as nearly half of all commodity funds with a five-year history.



A significant appeal of commodities as a portfolio ingredient is its historically low correlation to other asset classes. Assembling a portfolio whose components have low correlation with one another is crucial in maximizing the benefits of diversification.

From 1970 to 2011, the 42-year correlation between the S&P Goldman Sachs Commodity Index and U.S. large stocks was -0.06. But the Broad-Basket Commodity Funds chart shows that the correlation between U.S. large stocks and the various commodity funds has been considerably higher in recent years. Indeed, the correlation of monthly returns between the 10 commodity funds in this analysis and the S&P 500 ranged from 0.57 to 0.70 over the most recent five full years.

Correlations are a dynamic phenomenon - they are always changing. As shown in the Rolling Along graph below, the correlation between U.S. stocks (S&P 500) and commodities (S&P GSCI) has fluctuated widely over time. There have been periods in the past (the mid- and late-1980s, for example) when the performances of commodities and U.S. stocks were relatively highly correlated. The last five years were another period of higher correlations.

How long this will last, no one knows. Historically, high correlations do not necessarily persist.



The last test is how the various commodity funds contribute to a portfolio consisting of large U.S. stock and U.S. bonds. A typical "balanced" portfolio is 60% large U.S. stocks and 40% U.S. bonds. In this analysis, however, one-third of the U.S. stock allocation will be committed to commodities, creating a 40/20/40 portfolio, representing 40% large U.S. stocks, 20% commodities, and 40% U.S. bonds.

In this analysis, the portfolio was rebalanced annually to maintain the specified allocations. The U.S. large stock component is represented by the S&P 500, and U.S. bonds are represented by the Barclays Capital Aggregate Bond Index. Commodities are represented - one at a time - by the 10 different commodity mutual funds with five-year performance histories.

As shown in the chart below titled, A Tale of 10 Funds, the various commodity-based mutual funds had very different impacts when inserted into a three-asset 40/20/40 portfolio. With its position in the upper-left corner of the graph, DBC was the most beneficial commodity fund in terms of the risk-adjusted performance of the three-asset portfolio.

Another notable performer was PCRIX. When it was used as the commodity fund, the return of the three-asset portfolio was actually slightly higher than with DBC, but at the price of much higher volatility.

Quite clearly, not all commodity funds are created equal. They are different from one another, and they are also different in their impact within a multi-asset portfolio.

But picking a commodity fund on performance alone is shortsighted. Also important is the correlation of the commodity fund with the other assets in the portfolio.

As more commodity funds are introduced, the nuances among then will increase. In the end, the goal will always be the same: Find a commodity fund that adds value to an overall portfolio by virtue of its raw performance as well as by virtue of its low correlation with the other portfolio ingredients.



Craig L. Israelsen, Ph.D., is a Financial Planning contributing writer and an associate professor at Brigham Young University. He is the author of 7Twelve: A Diversified Investment Portfolio With a Plan.