On the relative merits of passive commodity investments

Given the current turmoil in financial markets, the search for alterative assets to diversify away from traditional equity portfolios is stronger than ever. Inspired by the diversification potential of commodities and the recent bull-run in commodity prices, the interest in commodity indexes and structured products has revived. This paper provides an overview of the relative merits of passive commodity investments. We evaluate the individual performance of commodities relative to traditional choices of asset allocation. Even though commodities generate equity-like returns , their substantial volatility and downside risk indicate that they do not present a good stand -alone investment. Nonetheless, we show that passive commodity investments are excellent vehicles /or portfolio diversification. Using the Fama & Schwert ( 1977 ) model, we further demonstrate that commodities are able to ( partially) hedge unexpected inflation. In the final part of our paper, we discuss the backwardation and contango character of the futures curve. We highlight the dynamics of the term structure and discuss the importance of the roll yield.