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Good volatile investments?

Recently we have started to add a small percentage of an institutional commodities futures fund to our clients (and, as always, my personal portfolio) to reduce portfolio volatility and increase long-term returns.

It may sound crazy that you can decrease your portfolio's volatility by adding a small amount, say 2 percent to 5 percent, of a risky investment to a portfolio, but I will try to explain why. First, let me say that I use the terms "risk" and "volatility" interchangeably. For most investors something that moves (up or down) a lot is considered a risky investment. Short term CDs don't have any volatility and essentially no risk. Commodity futures have significant volatility when used alone and therefore exhibit quite a bit of risk.

So why do I believe that commodity futures can help your portfolio? A commodity futures fund is a unique asset class with unique diversification properties. It is non-correlated with stocks and bonds, (usually doesn't go up or down at the same time) and historically, on average, commodity futures have performed very well during periods when stocks (and bonds) have done poorly.

Modern portfolio theory studies as well as in-depth portfolio optimization analyses, indicate that adding commodities (taken from a mix of stocks/bonds) reduces overall portfolio volatility slightly. Of course, the impact on the portfolio return depends on the actual returns for commodities versus stocks and bonds, but overall it is likely to have at least a marginally positive impact over the long-term.

Financial theory suggests that buyers of commodity futures ought to earn a real return, and empirical data confirm that theory. An unweighted index of commodity futures between 1959 and 2004 provided a return equal to the S&P 500 stock index, but with lower volatility. This means that the risk-adjusted return was actually a little better for the commodity futures than for stocks. This would show that a portfolio including commodity futures exhibited less volatility than a portfolio containing only stocks and bonds. Economists Gary Gorton and K. Geert Rouwenhorst reported these findings and more in their paper, "Facts and fantasies about commodity futures."

Of course, this investment is not appropriate for all investors. The volatility in commodities futures can lead to significant downside risks over the short term. For example, in late 1997 to 1998, during the emerging-markets currency crises and the long-term capital management meltdown, the DJ-AIGCI (commodity index) lost 37 percent. In 2001, after the tech bubble popped and fears of global deflation intensified, the index dropped about 22 percent. In both periods, equities also performed poorly and the touted non-correlation benefit didn't work.

Yet, I believe the long-term benefits of adding a small percentage of commodity futures to a portfolio of stocks and bonds outweighs the short-term risk of the investment. I also believe the current huge demand for commodities will last for many years due to the industrial demand from China and other emerging countries for oil, copper etc.

I am concerned that commodity futures have gone up significantly over the last few years and may be poised for a near-term pullback. You should be aware that commodity futures funds are very complicated investments and best used by buying a well-run mutual fund that has low costs.

If you think commodity futures might make a good addition to your portfolio I suggest you first discuss this with your investment advisor, understand the risks and then decide if a small amount of a risky investment in commodity futures may make sense in your retirement portfolio.

Raymond D. Mignone is a fee-only certified financial planner and registered investment advisor specializing in retirement planning and portfolio management. He can be reached in Little Neck for a no obligation consultation at 718-229-2514 or visit www.RayMignone.com.

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