Innovest Portfolio Solutions LLC 4643 South Ulster Street, Suite 1040 Denver, CO 80237

3036941900 www.innovestinc.com
1


Beyond the Asset Allocation of Commodities
W. Eric Overbey, CFA, Vice President
The use of commodities as a diversifying asset class has become increasingly common over recent years. Not only are
commodities characterized by low correlations to traditional asset classes over the long-run, but commodities also help
portfolios maintain purchasing power by hedging against an array of inflationary environments. What many investors
may fail to understand, however, is that the decision on how to implement commodities in a portfolio can be just as
important as the asset allocation decision for commodities.
Investors can gain exposure to commodities through both indirect and direct exposures. Indirect exposure consists of
investing in common stock of commodity producing companies. In theory, indirect commodity exposure should benefit
from changes in commodity prices passing to shareholders through profits. However, investors must accept additional
risks associated with owning a company rather than the underlying commodity (e.g., financial leverage, operating
leverage, and business risks) as well as higher correlations to broader equity markets. Alternatively, investors may gain
exposure through more direct methods, such as physical commodity ownership or commodity linked-derivates, which
eliminate added equity risk and contain greater diversification benefits.

Innovest Portfolio Solutions LLC 4643 South Ulster Street, Suite 1040 Denver, CO 80237
3036941900 www.innovestinc.com
2


Considering most investors lack the appropriate infrastructure to support physical storage of commodities, the use of
commodity futures contracts has become the preferred investment method. It is important for investors to understand
that the performance of commodity futures result from three primary return factors: 1. Spot Price, 2. Roll Yield, and 3.
Collateral. While investors may benefit from the change in the underlying commodity price (spot price), the shape of the
futures curve can significantly alter actual portfolio performance. This impact is due to the convergence of the futures
price with the underlying spot price as the contract nears maturity. If the futures price is trading above the current spot
price, the futures curve is said to be in contango. As a result, investors performance must overcome a negative carry
hurdle embedded in the commodity futures curve. The opposite may also be true if the futures curve is trading below
the underlying spot price, or backwardation. A study out of Yale University (Rouwenhorst, Gorton, & Hayashi, 2007)
attributes the shape of the commodities futures curve, and consequently the roll yield effect, to current supply of the
underlying commodity. Commodities with high inventory levels have demonstrated a greater tendency to trade in
contango (negative carry), while commodities with low inventory levels are characterized by backwardation (positive
carry). The result effect can have a material impact on performance, which can be illustrated by the underperformance
of futures based commodity indexes compared to the spot price returns of the underlying commodity constituents.
Lastly, since futures contracts are leveraged instruments, investors are required to post only a nominal amount of capital
to gain full notional commodity exposure. The remaining capital, therefore, can be utilized to enhance portfolio
performance through being invested in short-term fixed income instruments.


Innovest Portfolio Solutions LLC 4643 South Ulster Street, Suite 1040 Denver, CO 80237
3036941900 www.innovestinc.com
3



Commodities multifaceted return characteristics provide investors with the possibility to enhance performance through
a variety of implementation decisions. Passive implementation of commodities has historically been a common
approach among investors, by tracking a broadly diversified index such as the Dow Jones UBS Commodities index or a
global production-weighted index such as the Goldman Sachs Commodities Index. While a passive management
approach has worked well for equity investors, the decision between active and passive management is much more
complex for commodities. Unlike stocks, commodity sectors exhibit much lower correlation to one another, leaving
greater opportunity for active managers to add value. Moreover, a passive approach exposes investors to commodity
sectors exhibiting negative roll yields, which can challenge prospective performance.
One active commodities management method is to use enhanced index replication techniques, through active collateral
management and trading at optimal points on the futures curve. With the right expertise, active commodities managers
have the potential to outperform passive indexes through security selection and yield curve positioning. Nonetheless,
this approach may create unintended risks, which could expose the portfolio to interest rate and credit risk. Other
methods include frequent rebalancing schedules that seek to capitalize on the high degree of volatility among
commodities, or even the use of futures curve positioning to enhance performance by taking active long/short positions
on commodity sectors and sub-sectors. The structural persistence of many commodities to trade in either contango or
backwardation has even allowed investors to historically benefit by simply taking a long position in commodity sub-
sectors supported by a positive carry (backwardation) and a short position in sub-sectors characterized by a negative
carry (contango). Inherent pricing differentials between interrelated commodities may also create arbitrage
opportunities that can be capitalized by taking a concurrent long and short position in the respective under- and
overvalued commodities. These opportunities (referred to as crush and crack spreads) are typically created by short-
term disruptions, for example, Hurricane Katrinas impact on Gulf Coast gasoline refineries in 2005. Although a more
active approach could significantly enhance long-term performance, it carries implicit risks such as high active risk
(tracking error), which may not be suitable for investors unwilling to endure periods of underperformance.
1-Year 3-Years 5-Years 10-Years
Index/Futures Return
DJ UBS Commodity TR -13.32% 6.39% -2.07% 6.63%
S&P GSCI TR -1.18% 6.93% -2.79% 5.64%
Spot Return
DJ UBS Commodity Spot PR -8.12% 17.92% 7.87% 14.56%
S&P GSCI Spot 2.07% 22.71% 8.26% 14.32%

Innovest Portfolio Solutions LLC 4643 South Ulster Street, Suite 1040 Denver, CO 80237
3036941900 www.innovestinc.com
4



While we advocate an allocation to commodities for diversification benefits, we continue to believe that the
implementation decision is just as critical as the asset allocation decision for commodities. Statistically, more direct
methods discussed above have demonstrated more unique diversification characteristics than indirect methods, when
considered in the context of an investors aggregate portfolio, but the return factors of commodity futures have
challenges that must be carefully evaluated. We hope that an improved understanding of this intricate asset class will
help investors to make better informed decisions and go beyond the basic asset allocation decision of commodities.


The aftermath of Hurricane
Katrina caused near term
gasoline supply shortages,
resulting in rising gasoline
prices, as Gulf Coast
refinery production
dropped.