Mixing in dash of commodities

Pension funds seek a lift when stocks are sagging

Your Money

March 12, 2006|By GAIL MARKSJARVIS | GAIL MARKSJARVIS,TRIBUNE MEDIA SERVICES

Demco Inc. Chief Executive Officer Bill Stroner knows library supplies, not oil, gold, copper or any of the other commodities that have been such hot investments for the past four years.

But when his pension consultant told him last year that there are times when stocks stay in the doldrums for years while commodities soar, Stroner listened.

He and his benefits staff studied reports on commodities for nine months and decided to put a commodities mutual fund into the company 401(k). Now, the Pimco Real Return fund is one of 14 fund choices available to 500 employees who work for the Madison, Wis., company.

"I wish I'd done it sooner," Stroner said.

With the AIG Dow Jones Commodities index up 63.5 percent over the past four years, pension funds are adding commodities to their mix of stocks and bonds. The pioneers claim they aren't chasing a hot investment, but starting to view commodities as a basic part of the portfolio - one that continually belongs there to add zip while reducing overall risks, despite their volatility.

Pension plan strategy

In a 2005 survey of pension funds, the Russell Investment Group found that about 19 percent of pension plans are investing in commodities - mostly by using commodity indexes that invest in everything from oil and gold to wheat and livestock through futures contracts. Another 26 percent said they are considering them.

While large defined-benefit pension plans have tended to be the most adventurous with alternative investments, small 401(k) plans also are dabbling in commodities.

Like many small employers, Stroner wasn't necessarily looking for something new for the company's 401(k) plan. The idea came via a pension consultant, Michael Francis of Heartland, Wis. With stocks and bonds lackluster, and commodities soaring, Francis argued that there have been lengthy periods when commodities trumped stocks and bonds.

He turned to a growing area of academic research into commodities - research that has been sparked lately by the commodity craze. That research builds on what is known as modern portfolio theory - the theory that guides pensions and other investors as they try to build optimal portfolios.

The idea is to mix various types of stocks and bonds so that each cuts the risk of the other and enhances returns. The combinations are based on complex calculations.

So far, research into the proper use of commodities within the mix of stocks and bonds is in its infancy, said Tom Idzorek of Ibbotson Associates. But early research suggests there is a valid reason to put a portion of a portfolio into commodities, he said.

Although researchers are still in the process of quantifying the optimal use of commodities, Francis and numerous pension consultants have been drawing on research done by K. Geert Rouwenhorst, a Yale University finance professor, and Gary Gorton of the Wharton School at the University of Pennsylvania.

"Putting commodity futures with stocks and bonds maintains returns, but lowers risk," Rouwenhorst said.

He said investment theory has held that investors had to take greater risks to maximize returns. But his research suggests that simply by adding commodities to a portfolio, investors get more return without adding risk.

Investors often fear commodities because they are notoriously volatile. But Rouwenhorst said they tend to be the strongest investments during cycles when stocks are weak, and so the volatility works for investors, not against them.

And he said investors should not mistake commodities themselves with commodity futures contracts. He advocates investing in futures because they produce what is comparable to an insurance premium, so you earn a higher return than commodities themselves.

"It's about two parties agreeing to sell something in the future and locking in a price," he said. "It doesn't matter where the price of oil is today." With this approach, he said, investors have had long-term returns similar to stocks.

Henry Jarecki of Gresham Investment Management has had similar findings. He has been managing portfolios of commodities futures since 1987. He claims that commodities are less volatile than stocks, and notes that during the Depression stocks fell as much as 83 percent while commodities declined 34 percent.

Returns

During the past 18 years, Jarecki said, the average annual return in stocks was 11.59 percent, and in commodities it was 11.57 percent. And by mixing commodities into a broad portfolio of U.S. and international stocks, bonds and currencies, he says an investor would have cut risk by 3 percent and increased returns about 18 percent.

Yet the soaring four-year returns in commodities raise a question about whether investors will be making a mistake if they start entering an asset class close to a peak. Rouwenhorst's answer is that no one can ever be clear when a peak exists, so the wise approach is to simply move slowly into an investment.

For an individual investor, that means what's called dollar-cost averaging, or just adding a tiny part of each paycheck over many months.

Gina Sanchez, who builds mutual fund portfolios for American Century Investments, recently looked into adding gold to investments, and put the matter on the back burner.

She combines stocks and bonds into what are known as "target maturity" or "life cycle" funds so that investors have an investment mixture that will grow without being overly risky for their stage in life.

Sanchez has been using inflation-protected bonds and decided that they would give the portfolios the inflation hedge they needed.

gmarksjarvis@tribune.com

Gail MarksJarvis writes for Tribune Media Services.

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