In our previous market analyses, we examined strategies and metrics for fixed-income and equity funds. Fixed-income funds, with their stable returns and lower risk, provide a safe haven for investors, while equity funds attract those seeking higher returns through potential capital appreciation. However, as markets have continued to evolve and investors have pursued more diversified portfolios, our focus has gradually shifted to a broader realm - alternative investments.  

Within this domain, commodities and related commodity funds have garnered attention for their unique appeal and value. Commodities, as the foundation of the real economy, have prices influenced by a multitude of factors including global economic conditions, policies, and supply and demand dynamics, showcasing unique market dynamics. Commodity funds, on the other hand, are financial instruments that allow investors to conveniently participate in the commodity markets. By purchasing commodity funds, investors can indirectly hold a variety of commodities, achieve diversified asset allocation, and benefit from the opportunities presented by the commodity markets.

In the following sections, we will explore the characteristics, investment strategies, and relevant evaluation metrics of commodities and commodity funds. As with previous analyses, we will conclude with a case study illustrating the selection of a commodity fund.

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Commodity Funds

Commodities are categorized as alternative investments within the investment world, distinct from traditional investments like equities and fixed income. Delving into the role of alternative investments in a portfolio, we find that they are not merely supplementary but represent a strategic choice. Alternative investments, including commodities, offer investors exposures that differ significantly from traditional assets, often characterized by low correlations and unique return drivers. Previously, we analyzed the hedging role of gold in a portfolio.

Risk Diversification

From a risk diversification perspective, alternative investments can significantly reduce the overall risk of a portfolio. Traditional assets such as equities and fixed income are often influenced by similar economic and market factors, resulting in high correlations in their performance. However, alternative investments, especially commodities, are influenced by a variety of factors like supply and demand, weather, and geopolitical events, which are markedly different from those affecting traditional assets. Therefore, including commodities and other alternative investments in a portfolio can potentially lower the overall risk level.

Return Potential

From a return potential perspective, alternative investments often offer higher returns. This is because they cover a broader range of areas and involve more complex investment strategies, capturing market opportunities that traditional investments might miss. Commodities, as one such investment, exhibit significant price volatility, providing investors with opportunities for substantial gains. Of course, this also means higher risks, so investors need to balance risk and return when allocating assets.

If investors decide to incorporate commodity funds into their portfolios, in addition to general metrics like return rate, volatility, and Sharpe ratio discussed in previous articles, they should also consider commodity-specific metrics, such as:

• Beta on Equity (Beta on EQ): This measures the sensitivity of the fund’s returns to changes in the overall equity market. A beta greater than 1 indicates that the investment is more volatile than the equity market, while a beta less than 1 indicates greater stability. The smaller the beta, the lower the fund's correlation with the equity market, enhancing its role in risk diversification. Practically, this beta is often compared to the S&P 500 Index.

• Beta on Fixed Income (Beta on FI): This measures the sensitivity of the fund’s returns to changes in the fixed income market. A beta greater than 1 indicates that the investment is more volatile than the fixed income market, while a beta less than 1 indicates greater stability. The smaller the beta, the lower the fund's correlation with the fixed income market, enhancing its role in risk diversification. Practically, this beta is often compared to the Bloomberg Barclays U.S. Aggregate Bond Index.

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Commodity Fund Selection Example

Suppose we need to choose from three commodity funds: AQR Risk-Balanced Commodities Strategy (referred to as AQR RCS), Fidelity SAI Inflation-Focused (referred to as FID SAI), and DWS Enhanced Commodity Strategy (referred to as DWS ECS).

AQR RCS seeks returns through exposure to various commodity sectors including agriculture, energy, coffee, sugar, cocoa, metals, and carbon pricing, by investing in commodity-related derivatives. FID SAI aims to achieve inflation-protected returns by investing in commodity-related derivatives, inflation-indexed securities, U.S. Treasury securities, and cash or cash equivalents. DWS ECS invests in a wide range of commodity-related derivatives and combines this with a fixed income portfolio, aiming to provide a more stable source of returns for investors.

As in the previous article, we employ the Weighted Factor Rating Method to compare the three funds. Each quantitative metric is assigned a specific weight, and the final score is calculated accordingly. The fund with the highest score is deemed superior.

In this selection process, the primary metrics considered for the commodity funds include: three-month return (3M Return), one-year return (1Y Return), three-year return (3Y Return), one-year volatility (1Y Volatility), one-year Sharpe ratio (1Y Sharpe Ratio), dividend yield (Div Yield), beta on equity (Beta on EQ), beta on fixed income (Beta on FI), expense ratio, and fund size.

The example below illustrates how each metric is weighted and scored. Metrics that are more advantageous to investors are assigned higher scores. For instance, the score for the three-month return is derived by dividing its return by the sum of returns for all funds, with higher returns being more favorable. Given the one-year and three-year returns for FID SAI are far more negative, their scores are adjusted to be the absolute value of its return divided by the sum of absolute returns for all funds. Generally, a lower beta indicates a more pronounced risk diversification effect, so its score is calculated by dividing the reciprocal of its beta by the sum of the reciprocals of all fund betas, with lower beta funds receiving higher scores.

If investors are more conservative, we would place greater weight on volatility (20%), dividend yield (15%), equity beta (15%), and fixed income beta (15%). Under these criteria, AQR RCS would have a slight edge.

For investors with a higher risk tolerance, we would emphasize return rates (3M, 1Y, 3Y, totaling 30%) and the Sharpe ratio (20%). With these weightings, AQR RCS stands out due to its exceptional return rates and Sharpe ratio, earning the highest score.

If investors wish to balance all metrics equally, we would assign the same weight to each metric. In this scenario, AQR RCS remains the optimal choice.

When selecting a commodity fund, investors should consider a variety of factors beyond quantitative metrics like return rates. First, personal preferences and views play a crucial role in the decision-making process. For example, some investors may be particularly interested in precious metals like gold due to their inflation-hedging properties and safe-haven appeal during market turbulence. These investors might invest in funds focused on precious metals. Conversely, other investors might favor a diversified strategy, investing in funds that encompass a broad range of commodities such as energy, agricultural products, and industrial metals. They believe that such diversified investments can spread risk and yield benefits across different economic cycles.

Additionally, investors should understand that historical high returns do not ensure future performance. Commodity prices can be influenced by changes in market conditions, economic situations, and policies. Therefore, relying solely on past data for investment decisions is insufficient. Thus, investors should conduct thorough market research and analysis, considering the fund manager's expertise and experience, the fund's investment strategy, and its execution effectiveness.  

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Summary

To sum up, commodities present a wealth of opportunities and diversification options for investors. While the commodity markets are known for their elevated volatility, they also hold the potential for higher returns. In addition, commodities often exhibit low correlation to traditional financial assets, making them a compelling diversification tool. As investors navigate this space, establishing a robust evaluation framework will be key to making well-informed decisions. Poseidon will continue to monitor developments in the commodity domain and provide our audience with valuable insights.

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