Futures market participants are classified into hedgers, speculators (traders), and arbitrageurs. Commodity producers pass on the price risk that results from highly volatile and difficult to forecast commodity futures markets to speculators, and therefore pay a premium. Commodity producers have a distinct interest in hedging the price of their product in advance (a short hedge).

For example, consider the situation in the classic agricultural market. Farmers face a weather-dependent, volatile supply that is met by a relatively stable demand. Contrary to the maintenance cost for cattle breeding or the purchase cost of seed, the selling price is generally known only upon completion.

We see the opposite in the manufacturing industry: As the manufacturing industry hedges increasing commodity prices (a long hedge), the contrarian position to the commodity producers' short positions is taken. Airline companies, for example, often appear as long hedgers to guard against increasing fuel prices, the underlying in which the airline companies are short. If an existing or expected cash position is compensated for via an opposite future, the market participant is classified as a hedger. Hence, for the commodity producer, there is a fixed net profit; for the commodity manufacturer, there is a fixed purchase price.

Speculators represent the largest group in the futures markets. Their main task is to provide liquidity on the one hand, while balancing the long and short hedges on the other hand. Contrary to the commodity producers or the manufacturing industry, which try to avoid susceptibility to unfavorable price developments, the intention of speculators is to take a distinct market position and speculate for a price change. To make a profit, speculators deliberately take on risk by betting on rising or falling prices. As opposed to hedging, speculation is subject to both huge gains and huge losses, since speculators do not hold compensating cash positions.

The third and smallest group of market participants are the arbitrageurs, who try to take advantage of time-or location-based price differences in commodity futures markets, or between spot and futures markets, in order to generate riskless profits. Clearly, this group also intends to make profits, but their trading activity does not involve taking risky positions. Moreover, they use economic and financial data to detect existing price differences with respect to time and location. If these price differences exceed interlocal or intertemporal transfer costs like shipping, interest rates, warehouse costs, or insurance costs at the spot market, riskless profits can be realized. Consequently, price differences among the markets are adjusted, price relationships among the markets are restored, and arbitrageurs guarantee market balancing.

In the case of cash and carry arbitrage, the resale price of today's leveraged spot position is simultaneously set by selling the commodity futures. This short futures position implies an unconditional commitment to purchase the underlying at maturity. At maturity of the futures, the specified commodities are tendered against the maturing short futures. If the profit from the spot trade of the physical commodity exceeds the value of the futures plus the cost of debt financing, the arbitrageur will realize a profit from what is known as a basis trade.

Investments in international commodity markets differ greatly from other investments in several important ways. First, commodities are real assets—primarily consumption and not investment goods. They have an intrinsic value, and provide utility by use in industrial manufacturing or in consumption. Furthermore, supply is limited because in any given period, commodities have only a limited availability. For example, renewable commodities like grains can be produced virtually without limitation. However, their yearly harvest is strictly limited. In addition, the supply of certain commodities shows a strong seasonal component. While metals can be mined almost all year, agricultural commodities like soybeans depend on the harvesting cycle.

Another important aspect of commodities as an asset class is heterogeneity. The quality of commodities is not standardized; every commodity has its own specific properties. A common way to classify them is to distinguish between soft and hard commodities. Hard commodities are products from the energy, precious metals, and industrial metals sectors. Soft commodities are usually weather-dependent, perishable commodities from agricultural sector serving for consumptional purposes, such as grains, soybeans, or livestock such as cattle or hogs. Figure 57.1 shows the classification of commodity sectors.

Storability and availability (or renewability) are also important features of commodities. Since storability plays a decisive role in pricing, we distinguish between storable and nonstorable commodities. A commodity is said to have a high degree of storability if it is nonperishable and the costs of storage remain low with respect to its total value. Industrial metals such as aluminum or copper are prime examples: They fulfill both criteria to a high degree. In contrast, livestock is storable to only a limited degree, as it must be continuously fed and housed at current costs, and is only profitable in a specific phase of its lifecycle.

Figure 57.1. Classification of Commodity Sectors

Commodities such as silver, gold, crude oil, and aluminum are nonrenewable. The supply of nonrenewable commodities depends on the ability of producers to mine raw material in both sufficient quantity and quality.

The availability of commodity manufacturing capacities also influences supply. For some metals (excluding precious metals) and crude oil, the discovery and exploration of new reserves of raw materials is still an important issue. For given supply, the price of nonrenewable resources depends strongly on current investor demand, while the price of renewable resources depends more on estimated future production costs. (The events following Hurricane Katrina in 2005 clearly illustrated the insufficiency of the refinery capacities for crude oil and natural gas. Declining investment in this sector over the years has led to a bottleneck. The absence of investment in the industrial metals sector is also an issue for the supply side.)

The monetary benefit from holding a commodity physically instead of being long the respective futures is called the convenience yield. The convenience yield reflects market participants' expectations regarding a possible future scarcity of a short-term nonrenewable commodity.

There is a broad consensus among academics and practitioners that commodities compared to other alternative assets can be considered—in a portfolio context—as an asset class of their own. (In reality, most alternative investments like hedge funds or private equity are not an asset class of their own, but are considered alternative investment strategies within an existing asset class.) By definition, an asset class consists of similar assets that show a homogeneous risk/return profile (a high internal correlation), and a heterogeneous risk/return profile toward other asset classes (a low external correlation). The key properties are common value drivers, and not necessarily common price patterns. This is based on the idea that a separate asset class contains a unique risk premium that cannot be replicated by combining other asset classes (see Scherer, 2005). Furthermore, it is generally required that the long-term returns and liquidity from an asset class are significant to justify an allocation.

To describe existing asset classes, Greer (1997) explains the decomposition into so-called super classes: capital assets, store of value assets, and consumable or transferable assets. Continuous performance is a characteristic of capital assets. Equity capital like stocks provides a continuous stream of dividend payments, while fixed income guarantees regular interest payments in the absence of the default of the obligor.

Common to all capital assets is that their valuation follows the net present value method by discounting expected future cash flows. In contrast, real estate as an asset class has a hybrid classification. On the one hand, real estate can be classified as a capital asset because it promises a continuous rental stream and has market value. On the other hand, some features of real estate assets can justify their classification as store of value assets (for example, if the real estate is used for the owner's own purpose). Such store of value assets cannot be consumed, nor do they generate income; classic examples are foreign exchange, art, and antiquities.

Commodities belong to the third super class— consumable or transferable (C/T) assets. In contrast to stocks and bonds, physical commodities like energy, grains, or livestock, do not generate continuous cash flows, but rather have an economic value. Grains, for example, can be consumed or used as input goods; crude oil is manufactured into a variety of products. This difference is what makes commodities a unique asset class.

Hence, it is obvious that commodity prices cannot be determined by discounting future cash flows. Thus, interest rates have only a minor influence on the value of commodities. Moreover, commodity prices are the result of the interaction between supply and demand on specific markets (see Scott, 1994). In this context, it is not surprising that the capital asset pricing model (CAPM) cannot adequately explain commodity futures returns. As we have noted, commodities are not capital assets (see Erb and Harvey, 2006; Bodie and Rosanksy, 1980).

The line between the super classes is blurred in the case of gold. On the one hand, gold as a commodity is used in such things as electrical circuitry because of its excellent conductivity. On the other hand, gold as a store of value asset is a precious metal and is used for investment, similarly to currencies. The rising demand of commodities since the stock market downturn in 2002 clearly demonstrates this characteristic. Because gold can be leased, Anson has even classified it as a capital asset. (Precious metals like gold or platinum can generate a lucrative stream of income by being leased at market leasing rates. See Anson [2006].)

Another specific criterion that differentiates commodities from capital assets is that commodities are denominated worldwide in U.S. dollars. Furthermore, the value of a specific commodity is determined through global rather than regional supply and demand. In comparison, equity markets reflect the respective economic development within a country or a region.

The trading of commodity futures takes place at specialized exchanges that function as public marketplaces, where commodities are purchased and sold at a fixed price for a fixed delivery date. Commodity futures exchanges are mostly structured as membership associations, and operate for the benefit of their members. Transactions must be made as standardized futures contracts by a broker who is also a member of the exchange. Only members are allowed to trade. Membership in commodity exchanges is restricted to individuals who often act in the name of investment banks, brokers, or producers. The main task of a commodity exchange is to provide an organized marketplace with uniform rules and standardized contracts.

The first commodity exchange was founded by Japanese farmers trading rice futures contracts in Osaka. In the United States, the Chicago Board of Trade, founded in 1848, was the first institution. Even today, most commodities are still traded there. According to Geman (2005), in the United States most futures exchanges still function as open outcry trading systems, although many exchanges around the world operate on an electronic platform. The British London Metal Exchange was founded in 1877.

Energy futures trading, however, only began with the foundation of the International Petroleum Exchange (IPE) in London in 1980. Since 2005, the IPE operates under the name ICE Futures. Trading of WTI crude oil at the New York Mercantile Exchange (NYMEX) began in 1983; trading of Brent crude oil began in 1988. In terms of traded volume, the Chicago Mercantile Exchange (CME), founded in 1998, is the world's most important futures exchange. There are about 30 commodity exchanges worldwide; the most important are listed in Table 57.2. Based on traded volume, the majority of commodity futures trading takes place in the United States, the United Kingdom, Japan, and China.

Based on their historical return, risk, and correlation performance, commodity investments have an advantage over traditional assets, but exhibit some similarities to stocks. Kaplan and Lummer (1997), for example, conclude in their empirical investigation that commodities show an equity-like performance over the long run. This finding is also supported by many other studies such as Greer (2000), who concludes that the performance of unlever-aged commodity indices from 1970 to 1999 was on average positive, and comparable to equities with regard to return and volatility.

Bodie and Rosansky (1980) analyze an equally weighted commodity futures portfolio between 1949 and 1976, and Gorton and Rouwenhorst (2006) between 1959 and 2004. Both studies confirm equity-like returns for commodities. In addition, during the high inflation period of the 1970s, commodities had the highest real returns by far of all asset classes. Gorton and Rouwenhorst also found differences with traditional assets. They show that commodity returns exhibit positive skewness, in contrast to stocks, which have negative skewness and thus include higher downside risk.

Figure 57.2. Performance of the Goldman Sachs Commodity Index Compared to Other Financial Assets

Figure 57.2 shows the performance of both traditional and alternative assets starting with a reference basis of 100 in December 1993. After consolidating in 2006, the GSCI, which is heavily invested in energy currently shows very strong performance, along with indirect real estate and hedge funds. In contrast, equity investments in emerging markets show the smallest price increases.

During the January 1994-December 2006 period, commodities had an annualized arithmetic return of 9.64% (and geometric annualized mean of 7.61%) with a volatility of 20.25% (see Table 57.3). The high variability can be explained by the GSCI's large share in energy. The energy sector currently represents over 70% of the total index (as at end of 2006), and is itself composed of 40% crude oil, which has experienced extreme volatility over the last few years. Thus, compared to other observed asset classes, commodities have a high average volatility. Note, however, that the downside risk of the S&P 500 Composite, the S&P/IFCG Emerging Markets, and the FTSE/NAREIT Real Estate Index are higher because of their negative skewness; commodities possess positive skewness.

The most beneficial investment in terms of the Sharpe ratio is the CS/Tremont Hedge Fund Index. However, hedge fund investors also face high excess kurtosis. When considering only return and volatility, an indirect investment in real estate also seems less favorable due to negative skewness and positive excess kurtosis. Furthermore, the poor performance of emerging market equities seen in Figure 57.2 is also confirmed by the descriptive statistics, especially considering the geometric mean as well as the exorbitant volatility.

As mentioned above, commodities serve an important diversification function in asset allocation due to their long-term low correlation with stocks, bonds, real estate, hedge funds, and, to a lesser extent, their absolute performance characteristics. According to Greer (2000), commodity indices have a negative correlation with stocks and bonds and a positive correlation with the inflation rate, especially unexpected changes in inflation. There are, however, significant differences among the individual commodity sectors: Energy, metals, livestock, and sugar show the best inflation hedging potential. Greer also finds very high correlation coefficients among different kinds of commodity sectors.

According to Kat and Oomen (2007), commodity futures and traditional assets like stocks and bonds are uncorrelated. In specific phases, the correlation admittedly increases—therefore not all commodities are useful for portfolio diversification in every market phase. However, even in down markets, commodities as a group do not lose their diversification potential. According to Anson (2006), there are three reasons for low or negative correlations between commodities and stocks/bonds. First, inflation has a positive effect on commodity prices, but a negative effect on equity and bond markets. Second, investor expectations in commodity markets are different from those in equity and bond markets. Finally, a trade-off between capital return and commodity return exists in industrial production.

Table 57.4 shows the return correlation structure between the total return indices of various asset classes. As can be seen, correlation is significant only at the 5% level between commodities and hedge funds, which turn out to be relatively low at 0.167. This can be traced back to the commodity trading advisers (CTAs) and managed futures funds included in the CS/Tremont Hedge Fund Composite Index.

However, the return correlation between the money market and the commodity market is negative. Hence, the results of several academic studies are confirmed for our sample period: Commodities show a high diversification potential in traditional and alternative security portfolios. Chong and Miffre (2006) also find that conditional correlations between commodity futures and the S&P 500 decrease during times of down markets, that is, exactly when market risk increases and diversification is strongly needed. The conditional correlations between commodities and fixed income, on the other hand, increase during times of increased bond volatility.

In this section, we analyze whether an allocation in commodities yields any diversification benefits for a portfolio consisting of U.S. and global stocks, fixed income, and a riskless asset represented by the Treasury bill rate (that is, whether the efficient frontier shifts into the upper left corner in the expected return-standard deviation diagram). According to Markowitz (1952), these efficient portfolios (efficient in the sense that no others exhibit a superior risk/return combination) are located on the borderline formed by the set of all portfolios between the minimum variance (MVP) and the maximum return portfolio (MaxEP).

Table 57.4. Correlation Matrix

Figure 57.3. Expected Return-Standard Deviation (μ-σ) Portfolio Optimization (Monthly Returns in %)

Figure 57.3 shows how portfolio efficiency can be improved by including commodities in a traditional portfolio, thus rotating the efficient frontier counterclockwise around the MVP (the Treasury bill rate). The upward shift of the efficient frontier also provides higher risk-adjusted returns. The efficient frontier of the traditional portfolio is limited by a 98% investment in Treasury bills for the MVP, and 100% in the S&P 500 for the MaxEP.

Starting from the MVP and incorporating individual commodity sectors, the share of global bonds initially increases to 69% (see Figure 57.4). Subsequently, the proportions of the energy and industrial metals sectors increase continuously, together with the share of U.S. stocks. At a monthly return level of about 1%, livestock is represented with a share of about 4% to 5%. However, agricultural and precious metals are excluded entirely from the allocation. At a monthly return level of about 1.4%, the portfolio only consists of an allocation in the S&P 500 (28%), the energy sector (37%), and the industrial metals sector (35%).

Thus, with an increasing return level, the proportion of commodities in the portfolio expands as the allocation in U.S. stocks increases. It is remarkable that the GSCI Composite is not included in any allocations. It seems advisable to invest directly in the respective individual subsectors.

Figure 57.4. μ-σ-Portfolio Allocation (Monthly Returns in %)

An allocation to commodities offers not only a hedge against inflation, but also effective diversification because of their low correlation with traditional asset classes. Over the long run, commodity investments show equity-like returns, accompanied by lower volatility and lower shortfall risk. These advantages hold for passive investment in commodity futures indices, which are considered indicators of commodity market price movements. However, the futures indices of individual providers differ with regard to sector weights, index construction, and calculation method—hence there are tremendous variations in risk/return characteristics.

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