In recent years, investable commodity indices and commodity linked assets have increased the number of available commodity-based products. This paper provides both theoretical and empirical basis for the inclusion of commodities in investor portfolios. Results show that direct commodity investment can provide significant portfolio diversification benefits to traditional stock and bond portfolios and can provide return opportunities beyond those achievable from commodity-based stock and bond investment. Results also show that direct commodity based investment provides return and risk opportunities beyond that of simple inflation hedging. The impact of current commodity based index products is shown to be dependent on both the relative structure of the index products (e.g., sector allocations and reweightings) as well as the degree to which the indices are static or dynamic (reweighted based on expected price movements). Lastly results also show the impact of roll return on potential returns to long bias commodity indices and the market conditions most conducive to positive roll return.

We construct an equally-weighted index of commodity futures monthly returns over the period between July of 1959 and December of 2004 in order to study simple properties of commodity futures as an asset class. Fully-collateralized commodity futures have historically offered the same return and Sharpe ratio as equities. While the risk premium on commodity futures is essentially the same as equities, commodity futures returns are negatively correlated with equity returns and bond returns. The negative correlation between commodity futures and the other asset classes is due, in significant part, to different behavior over the business cycle. In addition, commodity futures are positively correlated with inflation, unexpected inflation, and changes in expected inflation.

Investment management professionals have been using managed futures for more than 30 years. More recently, institutional investors such as corporate and public pension funds, endowments and trusts, and banks have made managed futures part of a well-diversified portfolio. In 2004, it was estimated that over $130 billion was under management by trading advisors. The growing use of managed futures by these investors may be due to increased institutional use of the futures markets. Portfolio managers have become more familiar with futures contracts. Additionally, investors want greater diversity in their portfolios. They seek to increase portfolio exposure to international investments and nonfinancial sectors, an objective that is easily accomplished through the use of global futures markets.

Various managed futures return (e.g., CTAs) opportunities stem from the expanded universe of securities available to trade and the strategies that can be employed. Funds can access both financial and non-financial (commodity) markets and can easily take long or short futures and option positions in any of these markets. Expanding the set of investment opportunities results in providing diversification benefits to a portfolio that cannot be replicated through traditional stock and bond investment strategies.