go about choosing a commodity investment product especially when we have recently seen a proliferation of these products?

Transcription

1 white paper 2010 THE NEXT GENERATION OF COMMODITY INVESTING STRATEGIES Executive summary Spurred by global demand trends and concerns about inflation, more and more investors are turning to commodities to help diversify their portfolios and increase return potential. This report examines the dynamics that drive the commodities market and discusses ways for investors to participate in this unique asset class. Deutsche Asset Management believes that commodities which are basic goods such as oil, metals and livestock are an important part of a diversified portfolio. They provide low correlation to other asset classes and may serve as a hedge against rising interest rates and rising inflation. Moreover, the emerging markets are creating long-term demand for commodities. Despite these potential benefits, many investors have avoided commodity investment products due to their volatility. In our opinion, however, the volatility of commodity investment products stems from the fact that until recently, most of these products passively allocated to the asset class, riding volatile commodity prices for better or for worse. For instance, a commodity product might have the same exposure to crude oil if it is priced at $30 or $130 per barrel. We believe that active management can help address the volatility of commodity investment products, helping more investors participate in this important asset class. But how should investors go about choosing a commodity investment product especially when we have recently seen a proliferation of these products? In this report, we examine the differences between commodity investment products in order to evaluate which use strategies that may have the potential to increase risk-adjusted returns. We conclude that investors may want to consider three distinct characteristics in a commodity investment product: 1) the ability to re-weight commodities as needed, 2) the ability to enhance roll returns and 3) the ability to seek a measure of downside protection. Outline 1 An introduction to commodities (page 2) 2 Potential benefits of investing in commodities (page 3) 3 Unique challenges of investing in commodities (page 9) 4 Mechanisms of potentially reducing risk and adding alpha (page 13) 5 Choosing a commodity investment product (page 16) 6 Implementing commodities as part of a broad portfolio (page 18) CONTRIBUTORS Darwei Kung, portfolio manager, DWS Investments n Jonathan Diorio, portfolio specialist, DWS Investments William Chepolis, portfolio manager, DWS Investments (see page 19 for bios)

2 1 l AN INTRODUCTION TO COMMODITIES Commodities can be broken down into five broad sub-sectors: energy, base metals (also referred to as industrial metals), precious metals, agriculture and livestock. Energy includes brent crude oil, gas oil, heating oil, natural gas and WTI crude oil. Base metals include aluminum, coal, copper, iron ore, lead, nickel, steel, tin and zinc. Precious metals include gold, palladium, platinum and silver. Agriculture includes cocoa, coffee, corn, palm oil, rice rubber, soy meal, soybeans, soybean oil, sugar and wheat. Livestock includes feeder and liver cattle as well as lean hogs and pork bellies. Markets exist around the world to exchange commodities. However, some commodities are not traded on exchanges. For example, steel is essential to the global economy, with world production coming in at 1.22 billion metric tonnes in 2009, according to the World Steel Association. Compare that to aluminum production (which exceeds the combined production of all the other nonferrous metals) of just 53.6 million tonnes over the same period, according to the World Aluminum Market. Despite its significance to the global economy, steel is not traded on any global commodities exchanges. Why? Because the numerous grades of steel available make establishing a benchmark difficult. Thus, steel prices are typically determined by individual contracts between producers and consumers. Because some commodities are not traded on exchanges, investing directly in commodities may result in one having no exposure to certain raw materials. There are two types of transactions to buy and sell commodities: Direct physical trading, where commodities themselves are bought and sold, and derivatives trading, where contracts on commodities (such as futures) are bought and sold. UNDERSTANDING DERIVATIVES A derivative is a security whose price is based on an underlying asset. Common derivatives include futures, which are contracts obligating someone to buy or sell another asset (such as a stock or commodity) at a predetermined future date and price. It is worth noting that contracts to buy and sell commodities differ from contracts to buy and sell other assets (namely, stocks and bonds) in a number of ways. First, commodity contracts are not claims on corporations, but claims on real assets. Second, unlike contracts to buy or sell stocks and bonds, which can last forever, contracts on commodities tend to have a time limit (because commodities markets are seasonal). Third, contracts to buy or sell stocks and bonds are based on expectations of future gains or losses, so they are valued by attempting to predict future earnings. Commodity prices, on the other hand, are driven by supply and demand fundamentals. These differences result in different return and risk drivers between contracts to buy and sell commodities and contracts to buy and sell other assets. IMPORTANT risk information Commodity-related securities, including commodity-linked derivatives, create special risks for a commodity investment. Market price movements or regulatory and economic changes will have a significant impact on the investment s performance. Any investment that concentrates in a particular segment of the market will generally be more volatile than an investment that invests more broadly. A counterparty with whom the investment does business may decline in financial health and become unable to honor its commitments, which could cause losses for the investment. Bond investments are subject to interest-rate and credit risks. When interest rates rise, bond prices generally fall. Credit risk refers to the ability of an issuer to make timely payments of principal and interest. Investing in derivatives entails special risks relating to liquidity, leverage and credit that may reduce returns and/or increase volatility. Investing in foreign securities, particularly those of emerging markets, presents certain risks, such as currency fluctuations, political and economic changes, and market risks. A commodities investment is non-diversified and can take larger positions in fewer issues, increasing its potential risk. whitepaper // page 2

3 2 l Potential benefits of investing in commodities There are a number of reasons to consider investing in commodities, including low correlation to traditional asset classes, compelling return potential, exposure to world economic growth and a potential measure of protection against unforeseen events, rising inflation and a weak US dollar. Additionally, price trends in commodities tend to last a long time. We describe each reason to consider investing in commodities in more detail below. In the charts in this section, commodities are represented by the Dow Jones UBS Commodity Index. Natural resources stocks are presented by 50% MSCI World Materials Index and 50% MSCI World Energy Index. US stocks are represented by the S&P 500 Index. US bonds are represented by the Barclays Capital US Aggregate Index. US Treasury bills are represented by the Citigroup 3-Month Treasury Bill Index. Global stocks are represented by the MSCI World Index. Global bonds are represented by the Citigroup World Government Bond Index. US real estate is represented by the MSCI US REIT Index. See back page for index definitions. Commodities have exhibited low correlation to other major asset classes One of the main benefits of investing in commodities is their low correlation to traditional asset classes, such as stocks and bonds. Because portfolio volatility is a function of the correlation of the combined assets in a portfolio, adding commodities to a portfolio can potentially help diversify a portfolio and thus help mitigate its overall volatility. Of course, diversification neither assures a profit nor guarantees against loss. Commodities have exhibited low correlation to other major asset classes (15-year correlation as of 6/30/10) Commodities Natural resources stocks US stocks US bonds US Treasury bills Global stocks Global bonds US real estate Correlation for other time periods as of 6/30/10 5-year 10-year Commodities Natural resources stocks US stocks US bonds US Treasury bills Global stocks Global bonds US real estate Source: Morningstar, Inc. as of 6/30/10. Past performance is no guarantee of future results. Correlation is a measure of how closely two variables move together over time. A 1.0 equals perfect correlation, where variables more in the same direction. A 1.0 equals total negative correlation, where variables move in opposite directions. A 0 equals no correlation. The values of equity investments are more volatile than those of other securities. Fixed-income investments are subject to interest-rate risk, and their value will decline as interest rates rise. Commodities are long-term investments and should be considered part of a diversified portfolio; market-price movements, regulatory changes, economic changes and adverse political or financial factors could have a significant impact on performance. Equity index returns include reinvestment of all distributions. Index returns do not reflect fees or expenses, and it is not possible to invest directly in an index. See back page for index definitions. whitepaper // page 3

4 Commodities have provided compelling return and Volatility potential Most investors seek assets with low correlations, but they also want these assets to exhibit strong return potential. Commodities are one such asset class: While past performance does not guarantee future results, commodities have historically provided compelling returns with similar volatility as stocks as of 6/30/10, and the overall effect has been that commodities have helped enhance returns and lower volatility when added to a diversified portfolio. Commodities have provided compelling return and Volatility potential (average annual return and volatility as of 6/30/10) 10-year 15-year Return Volatility Return Volatility Commodities 4.41% 17.60% 5.38% 16.19% Natural resources stocks 4.98% 19.98% 5.84% 18.73% US stocks 1.59% 16.16% 6.24% 16.07% US bonds 6.47% 3.83% 6.39% 3.76% US Treasury bills 2.56% 0.54% 3.43% 0.55% Global stocks 1.02% 16.70% 4.68% 15.89% Global bonds 6.52% 7.47% 5.39% 6.99% US real estate 9.67% 25.60% 9.61% 22.13% Commodities have Helped Enhance returns and lower volatility when added to a hypothetical diversified portfolio (average annual return and volatility, 6/30/00 6/30/10) 4% Return 3% 2% 1% 45% US stocks, 45% US bonds, 10% commodities: 3.03% return, 8.13% volatility 50% US stocks, 50% US bonds: 2.74% return, 8.18% volatility 0% 0% 2% 4% 6% 8% 10% Volitility Return and volatility for other time periods as of 6/30/10 1-year 5-year Return Volatility Return Volatility 50% US stocks, 50% US bonds 12.34% 8.39% 2.69% 8.95% 45% US stocks, 45% US bonds, 10% commodities 11.39% 8.42% 2.43% 9.20% Source for both charts: Morningstar, Inc. as of 6/30/10. Past performance is no guarantee of future results. Volatility is represented by standard deviation, which measures an investment s volatility; the higher the standard deviation, the higher the volatility. The values of equity investments are more volatile than those of other securities. Fixedincome investments are subject to interest-rate risk, and their value will decline as interest rates rise. Commodities are long-term investments and should be considered part of a diversified portfolio; market-price movements, regulatory changes, economic changes and adverse political or financial factors could have a significant impact on performance. Equity index returns include reinvestment of all distributions. Index returns do not reflect fees or expenses, and it is not possible to invest directly in an index. See back page for index definitions. whitepaper // page 4

5 Commodities offer exposure to world economic growth The world s population has more than doubled in the past 50 years, and is expanding by more than 78 million people per year, according to the United Nations as of The world population is also becoming more urban. In 2010, 3.5 billion of the world s 6.9 billion people are estimated to live in cities. By 2030, 5 billion of the world s 8 billion people could live in cities, according to the United Nations as of Why does the growing and urbanizing population matter? Because as the world grows, it demands more commodities. As just one example, there has been a correlation between the growth of global gross domestic product (GDP) the value of all goods and services produced in an economy and the use of oil as far back as the 1980s. Commodities offer exposure to a growing, urbanizing population (world population growth, 1950 to 2030, in billions) 15 Population (billions) Urban population World population Source: United Nations, 2009 for urban data and 2008 for world data. GDP growth and oil demand have been correlated (percentage change in oil demand vs. percentage change in GDP growth, 1986 to 2009) 10% 8% While past performance is no guarantee of future results, this chart shows that oil demand and GDP growth have historically tended to move in the same direction. 6% 4% 2% 0% 2% 4% % change in oil demand % change in GDP growth Source: IHS Global Insight for percentage change in GDP growth, International Energy Agency for percentage change in oil demand, as of 12/31/09. whitepaper // page 5

6 Another way to understand how urbanization affects an economy is to compare motor vehicles statistics between the United States, which is one of the most urbanized nations, and China, which is in the process of urbanizing but still very rural. In 2010, the United States has 985 personal vehicles for every 1,000 drivers, while China has just 43 personal vehicles for every 1,000 drivers, according to JD Power. With three times the population of the United States, according to the United Nations, that gives China plenty of potential future demand for vehicles and plenty of future demand for the commodities used to manufacture them. EMERGING MARKETS DRIVE DEMAND FOR COMMODITIES The number of cars in China addresses the other big driver of commodities emerging countries' infrastructure spending. The emerging markets are modernizing and as countries develop, they spend more money on infrastructure, and infrastructure requires commodities. China and India are good examples: Each has a population of approximately 1 billion people who are demanding more food, more housing and more infrastructure. Commodities may offer a measure of potential protection against unforeseen events Commodities may help provide a measure of potential protection against geopolitical risk, such as wars and embargos, or other unforeseen events, such as earthquakes and hurricanes. That s because commodity prices are a function of supply and demand. Commodity prices tend to react differently to events that would otherwise be viewed negatively. For example, an earthquake, a war or an oil spill may negatively impact stocks of commodity-producing companies, because it disrupts supply, which impacts the ability of those companies to produce and sell their commodities. But this same disruption in supply may lead to higher commodity prices, potentially benefiting investors in direct commodities. Commodities may offer a measure of potential protection against rising inflation Many investors believe there has not been inflation in the United States since the 1970s. However, $100 in 1980 is worth only $37.86 today, according to the Consumer Price Index, a common measure of inflation. In other words, that $100 dinner in 1980 would now cost you $ Commodities may help provide a measure of potential protection against rising inflation because they are real assets, so their prices typically rise with inflation. In fact, going back to 1975, commodities have performed well in years when inflation has increased. Conversely, they have tended to underperform in years when inflation has decreased. Commodities have performed well when inflation has risen (average annual return, 12/31/75 12/31/09) 40% 30% Average inflation is the average US Consumer Price Index (CPI) inflation growth rate from 12/31/75 through 12/31/09, which was 4.5%. Inflation was considered rising when it was higher than it was one year prior. 20% 10% 0% 27.8% 6.2% 6.1% 28.3% 8.4% 5.9% Below average and rising Above average and rising Commodities Stocks Bonds Source: Morningstar, Bloomberg, FactSet as of 12/31/09. Past performance is no guarantee of future results. The chart above is for illustrative purposes only and does not represent any DWS fund. Commodities, bonds and stocks are represented by the S&P Goldman Sachs Commodities Index, Barclays Capital US Aggregate Index and S&P 500 Index, respectively. The values of equity investments are more volatile than those of other securities. Fixed-income investments are subject to interest-rate risk, and their value will decline as interest rates rise. Commodities are long-term investments and should be considered part of a diversified portfolio; market-price movements, regulatory changes, economic changes and adverse political or financial factors could have a significant impact on performance. Equity index returns include reinvestment of all distributions. Index returns do not reflect fees or expenses, and it is not possible to invest directly in an index. See back page for index definitions. whitepaper // page 6

7 WHAT IS INFLATION? Inflation is not always represented clearly by the media. That s because the media tends to use the core Consumer Price Index (CPI) to measure US inflation, and it may not show the whole picture. First, core CPI does not account for rising energy and food prices because these prices can be volatile. Second, 40% of core CPI consists of housing (depending on the exact CPI index used). Third, investors may also want to consider global price and currency movements, as US inflation can be affected by foreign factors. These dynamics may mean that instruments linked to core CPI may miss developing inflation trends. Commodities may offer a measure of potential protection against a weak US dollar Commodities may offer a measure of protection against a weak US dollar for two reasons. First, because commodities are denominated in US dollars, a weak US dollar drives commodities prices higher so producers can keep purchasing power parity for goods sold. Second, a weak US dollar may allow countries with appreciating currencies to buy commodities at cheaper prices. Commodities have performed well when the US dollar has declined (average annual return, 12/31/76 12/31/09) 24% 21% 18% 15% 12% 9% 6% 3% 0% The dollar is represented by the US Dollar Index (DXY). The chart shows the returns of different assets when the DXY was higher than it was in the year-ago period ("dollar up") or lower than it was in the year-ago period ("dollar down"). 6.4% 14.5% 9.8% 7.2% 12.4% 12.7% Commodities Bonds Stocks When dollar up When dollar down Source: Morningstar, Bloomberg, FactSet as of 12/31/09. Past performance is no guarantee of future results. The chart above is for illustrative purposes only and does not represent any DWS fund. Commodities, bonds and stocks are represented by the S&P Goldman Sachs Commodities Index, Barclays Capital US Aggregate Index and S&P 500 Index, respectively. The values of equity investments are more volatile than those of other securities. Fixed-income investments are subject to interest-rate risk, and their value will decline as interest rates rise. Commodities are long-term investments and should be considered part of a diversified portfolio; market-price movements, regulatory changes, economic changes and adverse political or financial factors could have a significant impact on performance. Equity index returns include reinvestment of all distributions. Index returns do not reflect fees or expenses, and it is not possible to invest directly in an index. See back page for index definitions. whitepaper // page 7

8 Price trends in commodity markets have tended to last a long time As we ve shown, adding commodities to a portfolio may potentially enhance risk-adjusted performance while giving investors access to world economic growth and providing a possible hedge against a number of unforeseen events. But there s one more reason to consider investing in commodities now: Price trends in commodity markets have tended to last a long time. From 1971 through 2009, stocks and commodities alternated seven times, during which time the commodity bull and bear markets have lasted approximately 18 years and we appear to be in the middle of a bull market for commodity prices. We may be in the middle of a bull market for commodities ( US stock prices vs. commodity prices, ) Relative price strength, stocks vs. commodities Post-Civil-War reconstruction ends in The gold standard begins in A deflationary boom ensues. Stocks rally. Progressivism enters US politics. The Panic of 1907 occurs when the New York Stock Exchange falls close to 50% from its previousyear peak. The Post-WWI commodity bubble bursts. Deflation ensues in A bull market begins. WWII takes place from 1914 to Gold is nationalized and the US dollar is devalued by twothirds in FDR's New Deal and reflation begin. The stock market crash of 1929 takes place. The Post-WWII commodity and inflation bubble bursts around Disinflation ensues. The Eisnehower equity bull market begins. LBJ's Great Society begins in The Vietnam War takes place. Nixon closes the gold window in Inflation ensues. US Federal Reserve Chief Paul Volcker curtails inflation from 1981 to Reagan cuts taxes. The Soviet Union collapses. Disinflation rises. A bull market begins. OPEC proclaims an oil embargo in The Iranian government falls in The Saudis flood the market with inexpensive oil in 1981, forcing price cuts by OPEC Stocks beat commodity returns and inflation eventually fell Commodities beat stock returns and inflation eventually rose Source: Bloomberg for US stock market, for Producer Price Index (PPI), as of 12/31/09. Past performance is no guarantee of future results. PPI is an index that measures the average change in selling prices received by domestic producers of goods and services over time. Each point is a 12-month average of the S&P Index divided by the 12-month average of the PPI for All Commodities Index. The chart does not include reinvested dividends. The values of equity investments are more volatile than those of other securities. Fixed-income investments are subject to interest-rate risk, and their value will decline as interest rates rise. Commodities are long-term investments and should be considered part of a diversified portfolio; market-price movements, regulatory changes, economic changes and adverse political or financial factors could have a significant impact on performance. Index returns do not reflect fees or expenses. It is not possible to invest directly in an index. See back page for index definitions. whitepaper // page 8

9 3 l Unique challenges of investing in commodities As we have shown, there are a number of reasons to consider investing in commodities, including low correlations, compelling return potential, exposure to world economic growth and a potential measure of protection against unforeseen events, rising inflation and a weak US dollar. However, there are also many unique challenges of investing in commodities. Some of these challenges are basic. For example, the commodities market consists of many participants, including producers, longterm investors and speculators the latter of whom may have short-term horizons, meaning their trading can quickly impact supply and demand dynamics in the commodity market. In the past, some investors have speculated on individual commodities or tried to time the market to invest in commodities over shorter time periods. The risk of this investment strategy is that because commodity investments are volatile, selecting ideal commodities or entry points can be difficult. Investing in a diversified basket of commodities may help lower volatility. The chart below shows the volatility of the 19 commodities that comprise the Dow Jones UBS Commodity Index as well as the volatility of the index itself. As you can see, in most cases, investing in a basket of commodities has reduced volatility vs. investing in individual commodities. This is interesting given the popularity of products that track single commodities, such as crude oil and natural gas. Diversifying exposure to commodities may help lower volatility (three-year volatility of various commodities as of 6/30/10) Aluminum Coffee Copper Corn Cotton Crude oil Heating oil Lean hogs Live cattle Nickel Silver Soybean oil Soybeans Gold Natural gas Sugar Unleaded gas Wheat Zinc Dow Jones UBS Commodity Index 28.60% 32.11% 36.95% 35.26% 31.37% 41.38% 36.95% 27.93% 12.34% 44.18% 35.93% 35.67% 33.65% 22.85% 41.86% 42.76% 41.76% 39.79% 35.87% 23.93% 0% 10% 20% 30% 40% 50% Source: Morningstar, Inc. as of 6/30/10. Past performance is no guarantee of future results. The chart above is for illustrative purposes only and does not represent any DWS fund. Commodities are represented by Dow Jones UBS Commodity Index sub-indices. Volatility is represented by standard deviation, which measures an investment s volatility; the higher the standard deviation, the higher the volatility. Index returns assume reinvestment of all distributions. Index returns do not reflect fees or expenses and it is not possible to invest directly in an index. See back page for index definitions. See next page for volatility over other time periods. whitepaper // page 9

10 Volatility for other time periods as of 6/30/10 5-year 10-year Volatility for other time periods as of 6/30/10 5-year 10-year Aluminum 25.08% 20.62% Silver 33.93% 29.21% Coffee 28.01% 31.49% Soybean oil 29.97% 29.61% Copper 35.72% 30.29% Soybeans 29.08% 28.07% Corn 33.12% 28.19% Gold 20.12% 17.11% Cotton 26.64% 29.83% Natural gas 51.62% 55.95% Crude oil 35.24% 33.91% Sugar 38.85% 34.46% Heating oil 33.65% 33.63% Unleaded gas 41.45% 37.72% Lean hogs 24.86% 25.42% Wheat 34.17% 28.61% Live cattle 13.10% 14.95% Zinc 38.17% 30.02% Nickel 42.74% 40.97% Dow Jones UBS Commodities Index 20.53% 17.60% Source: Morningstar, Inc. as of 6/30/10. Past performance is no guarantee of future results. The chart above is for illustrative purposes only and does not represent any DWS fund. Commodities are represented by Dow Jones UBS Commodity Index sub-indices. Volatility is represented by standard deviation, which measures an investment s volatility; the higher the standard deviation, the higher the volatility. Index returns assume reinvestment of all distributions. Index returns do not reflect fees or expenses and it is not possible to invest directly in an index. See back page for index definitions. But investing in a diversified basket of commodities cannot eradicate all of the challenges of investing in commodities. To explain why, it s important to understand how traditional commodity indices which include the Dow Jones UBS Commodity Index, the S&P Goldman Sachs Commodities Index (GSCI) and the Deutsche Bank Liquid Commodities Indices (DBLCI) and the products benchmarked to them (which we will henceforth refer to as strategies ) work. These strategies invest in a static number of commodities with weights that do not change (which is why these strategies are referred to as passive commodity investing strategies). As a result, passive commodity investing strategies have a number of limitations: They can be static, they roll futures contracts on a predefined schedule (which can decrease return potential) and they can be volatile. Let s look at each limitation in more detail. Limitation 1: Traditional commodity investing strategies can be static Traditional commodity investing strategies typically set weights based on commodities with the largest trading volume or greatest global consumption. For example, an index based on world consumption, such as the S&P GSCI, may have a high weighting to energy because energy commodities (specifically oil) dominate world consumption. Because energy commodities can be volatile, this method may potentially lead to greater volatility. High energy weighting in traditional commodity indices may increase volatility (commodity index sector weights as of 6/30/10) 70% 60% 50% The S&P GSCI has more than double the energy weighting of the Dow Jones UBS Commodity Index, which has resulted in the S&P GSCI having 30% more volatility over the past five years ending 6/30/10 (a standard deviation of 28.25% vs % for the Dow Jones UBS Commodity Index). 40% 30% 20% 10% 0% 3.65% 5.07% 69.63% 31.84% 13.83% 29.12% 7.83% 17.59% 14.59% 6.86% Energy Agriculture Industrial metals Precious metals Livestock S&P GSCI Dow Jones UBS Commodity Index Source: DWS as of 6/30/10. Past performance is no guarantee of future results. See back page for index definitions. whitepaper // page 10

11 Limitation 2: Traditional commodity investing strategies roll futures contracts on a predefined schedule As we explained earlier, investing in commodities entails buying a contract to buy or sell a specific commodity on a specific date. This contract, called a future, typically expires monthly. When that happens, passive commodity investing strategies automatically purchase or roll into the next available contract, which may be higher-priced. This can negatively impact returns. Additionally, passive commodity investing strategies may experience increasing difficulty as they all generally roll into the same contracts on the same days, leading to more crowded trading. The chart below illustrates the potential negative effect of automatically rolling into the next available contract. The spot price of natural gas (which is simply the price at which a particular commodity can be currently bought or sold) rose twofold over the past 10 years ending 12/31/09. At the same time, an investment in natural gas contracts that was continually rolled to the next month s contract declined almost 95% over the same period. In other words, the natural gas contracts would be almost worthless today. Natural gas illustrates the negative effects of a passive rolling strategy ( S&P GSCI natural gas excess return vs. spot return, 12/31/99 12/31/09) 600 Spot return and excess return index GSCI natural gas excess return GSCI natural gas spot retun Source: DeAM and Bloomberg as of 12/31/09. Past performance is no guarantee of future results. The graph above is for illustrative purposes only and does not represent any DWS fund. Index returns assume reinvestment of all distributions and do not reflect fees or expenses. It is not possible to invest directly in an index. whitepaper // page 11

12 Limitation 3: Traditional commodity investing strategies can be volatile Most commodity indices set commodity weights at the beginning of each year. These weights then drift with price changes throughout the year. Those price changes can be significant. As the chart below illustrates, returns for the more liquid commodities in the Dow Jones UBS Commodity Index have varied dramatically from quarter to quarter during the past three years ending 6/30/10. On average, the difference in return between the best- and worst-performing commodity in the Dow Jones UBS Commodity Index on a quarter-toquarter basis is approximately 35% over the past three years, according to Morningstar as of 6/30/10. The result is that some commodities gain disproportionately high weightings and events that impact those commodities can cause significant volatility in those indices and the commodity investing strategies that are benchmarked to them. Additionally, because commodity prices can be cyclical, when global demand is weak, commodities can go through extended periods of negative returns. This was made clear during 2008 when the Dow Jones UBS Commodity Index returned 35.65%, according to Morningstar erasing years of commodity gains. Varying commodity Weights can lead to significant volatility (quarterly returns over past three years ending 6/30/10) 2007 Q Q Q Q Q Q Q Q Q Q Q Q Q2 Gold 2.45% 14.36% 11.81% 9.20% 0.68% 5.72% 0.24% 4.23% 0.09% 8.54% 8.49% 1.45% 11.67% Heating oil 7.10% 6.75% 18.59% 12.97% 37.22% 27.95% 52.76% 8.35% 23.95% 3.26% 9.69% 1.84% 9.84% Crude oil 0.56% 17.05% 20.71% 6.71% 39.87% 28.32% 56.29% 18.69% 26.33% 4.75% 6.67% 3.47% 13.57% Corn 13.05% 5.54% 17.99% 22.06% 25.29% 36.07% 20.11% 3.13% 16.28% 4.57% 16.11% 19.36% 0.69% Wheat 30.02% 54.40% 7.57% 2.71% 10.32% 22.86% 13.49% 14.72% 5.08% 19.81% 13.97% 19.27% 0.07% Aluminum 2.72% 8.72% 5.73% 22.94% 2.90% 23.32% 38.28% 12.10% 14.85% 14.24% 16.05% 2.66% 16.15% Highest 30.02% 54.40% 20.71% 22.94% 39.87% 5.72% 0.24% 4.23% 26.33% 14.24% 16.11% 3.47% 11.67% Lowest 13.05% 8.72% 7.57% 2.71% 10.32% 36.07% 56.29% 18.69% 16.28% 19.81% 6.67% 19.36% 16.15% Difference 43.06% 63.12% 28.28% 20.23% 50.19% 30.36% 56.53% 22.92% 42.60% 34.05% 9.45% 22.83% 27.82% Source: Morningstar, Inc. as of 6/30/10. Past performance is no guarantee of future results. The chart above is for illustrative purposes only and does not represent any DWS fund. Commodities are represented by Dow Jones UBS Commodity Index sub-indices. Index returns assume reinvestment of all distributions. Index returns do not reflect fees or expenses and it is not possible to invest directly in an index. See back page for index definitions UNDERSTANDING ALPHA Alpha refers to returns above and beyond those of a benchmark. whitepaper // page 12

13 4 l Mechanisms of potentially reducing risk and adding alpha Given the challenges of investing in commodities, investors may want to look for three distinct abilities when considering a commodity investment product: 1) the ability to re-weight commodities as needed, 2) the ability to enhance roll returns, and 3) the ability to seek a measure of downside protection in volatile markets. In examining these abilities, we look at three next-generation Deutsche Bank Liquid Commodity Indices (DBLCI), which were designed to address many of the limitations of passive commodity investing strategies. Characteristic 1: the ability to re-weight commodities as needed Addresses limitation 1: Traditional commodity investing strategies can be static On 2/28/03, Deutsche Bank launched an index called the DBLCI Mean Reversion (DBLCI-MR). The goal of the DBLCI-MR was to address the changing price dynamics of various commodities by exploiting the tendency of commodity prices to trade within wide but defined ranges. Commodity prices tend to mean revert i.e., eventually move back towards their mean or average because of supply and demand factors. The reason is based on fundamental economics. If the price of a commodity falls below a threshold, profit margin for producers will be squeezed and weaker players will exit the market; at the same time, demand will increase, driving the price up. Generally, if the price of a commodity rises too high, consumers will substitute it with another commodity or will reduce consumption, when possible; at the same time, higher margins will drive supply up and bring prices down. Accordingly, individual commodity weights in the DBLCI MR are re-balanced so that expensive commodities have their weights reduced while cheap commodities have their weights increased according to a pre-defined formula. This process, which is rules-based, looks at differences in one-year and five-year average prices to weight commodities. In the chart below, we compare the DBLCI MR to a passive commodity investing index, the DBLCI. The DBLCI compares well with the DBLCI MR because it invests in the same commodities (six of the most liquid commodities, namely crude oil, heating oil, corn, wheat, aluminum and gold with the same weights). As you can see from the chart below, the DBLCI MR s re-weighting methodology has generated compelling excess returns over the three available time periods. Re-weighting has increased risk-adjusted return potential (average annual return, volatility and Sharpe ratio as of 6/30/10) Index and inception date Average annual return Average annual volatility Sharpe ratio 1-year 3-year 5-year 1-year 3-year 5-year 1-year 3-year 5-year DBLCI (2/28/03) 2.31% 7.60% 0.62% 18.51% 28.63% 24.03% DBLCI-MR (2/28/03) 0.91% 1.54% 9.55% 19.50% 27.06% 23.32% Difference between DBLCI-MR and DBLCI +3.22% +6.06% % +0.99% 1.57% 0.71% Source: DeAM, Bloomberg and Morningstar, Inc. as of 6/30/10. Past performance is no guarantee of future results. Volatility is represented by standard deviation, which measures an investment s volatility; the higher the standard deviation, the higher the volatility. Sharpe ratio measures risk-adjusted performance; the higher the Sharpe ratio, the better the risk-adjusted performance. Index returns assume reinvestment of all distributions and do not reflect fees or expenses. It is not possible to invest directly in an index. See back page for index definitions. whitepaper // page 13

14 Characteristic 2: the ability to enhance roll returns Addresses limitation 2: Traditional commodity investing strategies roll futures contracts on a predefined schedule On 5/31/06, Deutsche Bank launched an index called the DBCLI Optimum Yield (DBLCI OY). As we explained earlier, investors in passive commodity investing products, which roll automatically into the higher-priced future contract at expiration, may potentially experience a lower return since they are continually buying high. The DBLCI OY is designed to address this problem by carefully selecting the futures contracts that a commodity investing strategy rolls into at expiration. In the chart below, we compare the DBLCI OY to a passive commodity investing index, the DBLCI. The passive DBLCI compares particularly well with the DBLCI OY because it invests in the same commodities (six of the most liquid commodities, namely crude oil, heating oil, corn, wheat, aluminum and gold) with the same weights. As you can see from the chart below, the DBLCI OY s methodology has generated compelling excess returns over the two available time periods. Enhancing roll returns has increased risk-adjusted return potential (average annual return, volatility Sharpe ratio as of 6/30/10) Index and inception date Average annual return Average annual volatility Sharpe ratio 1-year 3-year 1-year 3-year 1-year 3-year DBLCI (2/28/03) 2.31% 7.60% 18.51% 28.63% DBLCI OY (5/13/06) 1.27% 3.29% 19.37% 27.74% Difference between DBLCI OY and DBLCI +1.04% +4.31% +0.86% 0.89% Source: DeAM, Bloomberg and Morningstar, Inc. as of 6/30/10. Past performance is no guarantee of future results. Volatility is represented by standard deviation, which measures an investment s volatility; the higher the standard deviation, the higher the volatility. Sharpe ratio measures risk-adjusted performance; the higher the Sharpe ratio, the better the risk-adjusted performance. Index returns assume reinvestment of all distributions and do not reflect fees or expenses. It is not possible to invest directly in an index. See back page for index definitions. whitepaper // page 14

15 Characteristic 3: the ability to seek a measure of potential downside protection in volatile markets Addresses limitation 3: Traditional commodity investing strategies can be volatile Finally, we look at the ability to allocate away from commodities if the asset class as a whole appears too expensive. Here we examine the DBLCI-MR Plus, which Deutsche Bank launched on 6/20/07. This index combines the DBLCI-MR s approach to re-weighting commodities with a quantitative, rules-based methodology that address the fact that commodities can suffer prolonged periods of negative returns particularly in environments where global demand is weak and seeks to help immunize returns from such downturns. To do so, the DBLCI-MR Plus attempts to detect longer-term commodity cycles by differentiating between short-term price movements and long-term trends. Based upon its methodology, in periods when exposure to commodities is relatively high, any sharp drop in commodity returns will lead to an immediate and significant reduction in the DBLCI-MR Plus s exposure to commodities. A series of moderate, negative returns over time will lead to a gradual reduction in the exposure to commodities. The opposite is the case during upturns, when exposure to commodities is relatively low. Money not allocated to commodities is allocated to US Treasury bills. Thus, if the DBLCI-MR Plus were fully allocated to commodities, it would have the same returns as DBLCI-MR. If it were fully allocated away from commodities, it would have the same returns as US Treasury bills. Since the DBLCI-MR Plus utilizes the same dynamics as the DBLCI-MR, with one addition the ability to allocate away from commodities we can look at the difference between the two indices to determine how the DBLCI-MR Plus s downside protection component affects return and volatility. As you can see from the chart below, the DBLCI-MR Plus methodology may underperform in the bull markets seen in the past year, but it may have the potential to help improve performance and lower volatility over the longer term. DBLCI-MR Plus may increase risk-adjusted return potential over longer-term periods (average annual return, volatility and Sharpe ratio as of 6/30/10) Index and inception date Average annual return Average annual volatility Sharpe ratio 1-year 3-year 1-year 3-year 1-year 3-year DBLCI-MR (2/28/03) 0.91% 1.54% 19.50% 27.06% DBLCI-MR Plus (6/20/07) 6.45% 8.88% 16.13% 18.41% Difference between DBLCI-MR Plus and DBLCI-MR 7.36% % 3.37% 8.65% Source: DeAM, Bloomberg and Morningstar, Inc. as of 6/30/10. Past performance is no guarantee of future results. Volatility is represented by standard deviation, which measures an investment s volatility; the higher the standard deviation, the higher the volatility. Sharpe ratio measures risk-adjusted performance; the higher the Sharpe ratio, the better the risk-adjusted performance. Index returns assume reinvestment of all distributions and do not reflect fees or expenses. It is not possible to invest directly in an index. See back page for index definitions whitepaper // page 15

16 5 l Choosing a commodity investment product While a number of mutual funds offer access to commodities through stocks of commodity-related companies, investments in direct commodities (i.e., commodity futures) through mutual funds remain relatively new to the typical investment portfolio. It wasn t until 2009 that Morningstar created a direct commodity mutual fund category in the United States. Today, investors can gain access to commodities in a number of ways. However, most commodity investing products fit into five main categories. In this section, we ll look at each in more detail. GROWTH OF AN ASSET CLASS The direct commodities asset class, as represented by the newly created Commodities Broad Basket Morningstar category, has garnered more than $12 billion in new sales in the past year alone, according to Strategic Insight Simfund as of 12/31/09. This growth is impressive compared to Morningstar s Natural Resource category, which garnered $4.8 billion in assets, or other alternative categories, such as Real Estate ($3.7 billion) and Long-Short ($6.9 billion) during the same time period. Natural resource stock funds Natural resource stock funds typically invest in the stocks of companies that produce natural resources. A benefit of investing in natural resource stock funds is that they offer exposure to commodities that investors would not typically obtain by investing directly in direct commodities. One example is steel, which, as we explained earlier, is not traded on any global commodity exchange. Natural resource companies can also attempt to manage some of the risk associated with weaker commodity demand by cutting back capacity and managing resources and capital. volatility and correlation, natural resource stock funds may lack the diversification benefits that direct commodity investments may provide. Passive commodity investment products Passive commodity investment products typically track passive commodity indices, such as the Dow Jones UBS Commodity Index, S&P GSCI and DBLCI. Because these products tend to be inexpensive, they may be an option to consider for investors looking to gain cheap access to the commodities market. As we ve shown, however, passive commodity investing strategies have a number of limitations: They re static, they can be volatile and they roll futures contracts on a predefined schedule, which may decrease returns. Passive commodity investment products with collateral alpha drivers We believe investing in commodities is capital-efficient, meaning it only takes a small portion of a product s assets to gain full exposure to the commodities market. As a result, a large portion of a commodity product s assets can be invested outside of commodities. This investment outside of commodities is called a collateral portfolio and some passive commodity investment products seek to add value through this collateral portfolio. To understand how a collateral portfolio works, consider the hypothetical example of an individual who wants to invest $100 in commodities. This investor might gain $100 worth of exposure to the commodities market by purchasing a commodity futures contract for $25. The remaining $75 could be invested elsewhere perhaps in fixed-income investments. These noncommodity investments would be considered a collateral portfolio. However, while past performance does not guarantee future results, natural resource stocks have actually exhibited higher volatility than direct commodities over the past 10 and 15 years ending 6/30/10, as shown on page 5. Additionally, natural resource stocks exhibit high correlation to the S&P 500 Index. Over the past 10 years ending 6/30/10, natural resource stocks had a 0.75 correlation to the S&P 500 Index. Given this high historical The collateral portfolio, given its investments in other types of securities, may add another level of diversification and the potential to improve returns. Of course, diversification neither assures a profit nor guarantees against loss. However, investors should be aware of new risks added by a collateral portfolio. For instance, a collateral portfolio may whitepaper // page 16

17 be invested in longer-term bonds, which could be negatively impacted by rising inflation and rising interest rates a scenario that may not correspond with the reason the investor is investing in commodities in the first place (to hedge against inflation, for example). Other risks that may be introduced by a fixed-income collateral portfolio include interest-rate risk and credit risk. Long-short commodity investment products Long-short products, in addition to buying securities (i.e., taking long positions), also sell securities short, which involves selling borrowed securities in anticipation of a price decline, then returning an equal number of the securities at some point in the future. Long-short commodity investment products are often referred to as managed futures or commodity trading advisors (CTAs). They typically trade commodities, along with other futures contracts, both long and short. These products seek to create returns regardless of dynamics in the commodity market, and they seek to provide diversification and downside protection potential. However, long-short commodity investment products may underperform in commodity or equity bull markets. That s because they typically aren t benchmarked to a commodity index, and they tend to have little correlation to any asset class, including commodities. For example, these products (as represented by the Barclay CTA Index) had a correlation of only 0.32 to direct commodities (as represented by the Dow Jones UBS Commodity Index) over the past 10 years ending 12/31/09, according to Morningstar. Actively managed commodity investment products Actively managed commodity investment products have the ability to overweight and underweight commodities in much the same way that some stock-fund managers overweight and underweight stocks in the S&P 500 Index. Actively managed commodity investment products may have the potential to outperform traditional passive commodity benchmarks because individual commodities have different supply and demand dynamics and can be driven by different factors at different times. For instance, a bad corn harvest may lead to higher agricultural prices but may not increase the price of industrial metals. Overall, the product s manager and the manager s investment process are some of the most important elements to examine when investing in an actively managed commodity investment product (as well as a long-short commodity investment product), since you re betting on the manager s ability to go long (or overweight) individual commodity winners and go short (or underweight) the losers. THE POTENTIAL BENEFIT OF managing ALLOCATIONS Commodities consist of a number of distinct sectors (energy, agriculture, base metals, precious metals and livestock), each of which has unique characteristics. Different commodities indices have different weights to these sectors. For example, some provide more than 70% allocation to energy, while others provide closer to 30%. In our view, neither is optimal. In some market environments, investors may want to increase exposure to energy. In other market environments, they may want to reduce it. Thus, some products overweight and underweight commodities. Overweighting means having a higher weighting in a given sector or security than a benchmark; underweighting means having a lower weighting. Selecting a commodity investment product Investors should examine their objectives when choosing a commodity investment product. Investors who want to make their own tactical decisions meaning they decide when to enter and exit the market or who are cost sensitive may prefer passive commodity investment products. Investors who are seeking absolute return potential may prefer long-short commodity investment products. However, longer-term investors seeking long exposure with an element of alpha and risk management may prefer actively managed commodity investment products. Consider the risks All of these products have risks. Stocks may decline in value. Also, because these products invest in commodity-related securities, including commodity-linked derivatives, they may subject the fund to special risks. Because they concentrate in a particular segment of the market, they will generally be more volatile than products that invest more broadly. Market-price movements or regulatory and economic changes will have a significant impact on their performance. Investing in derivatives entails special risks relating to liquidity, leverage and credit that may reduce returns and/or increase volatility. Short sales could magnify losses and increase volatility. Additionally, a counterparty with whom the product does business may decline in financial health and become unable to honor its commitments, which could cause losses for the product. whitepaper // page 17

18 6 l Implementing commodities as part of a broad portfolio As we ve explained, there are a number of reasons to consider investing in commodities, including low correlation to traditional asset classes, compelling return potential, exposure to world economic growth, and a potential measure of protection against unforeseen events, rising inflation and a weak US dollar. Additionally, we have seen a tremendous amount of assets flowing into fixed-income portfolios, and commodities may help complement the fixed-income portion of a portfolio given that commodities may benefit from rising interest rates while fixedincome assets may be negatively impacted. Investing in commodities is not without risks, however. Speculators may have short-term horizons, and their trading can quickly impact supply and demand dynamics in the commodity markets. The influx of investment money into the commodity markets has caused increased tightness in some markets, especially in the front months, when many passive indices or products roll their contracts. Commodities prices can be cyclical, and when global demand is weak, they can go through extended periods of negative returns. (Commodities are longterm investments and should be considered part of a diversified portfolio, as market-price movements, regulatory changes, economic changes and adverse political or financial factors could have a significant impact on performance.) In an attempt to maximize the benefits and minimize the risks, in the past decade there have been a number of developments in the way commodity exposure is constructed. In particular, direct investments in commodities have become more widespread. We believe investors should consider allocating a piece of their alternative portfolio to this asset class using a risk-conscious approach to complement traditional stocks and bonds. Given the unique challenges of investing in commodities, investors may want to look for three distinct abilities when considering a commodity investment product: 1) the ability to re-weight commodities as needed, 2) the ability to enhance roll returns, and 3) the ability to seek a measure of downside protection in volatile markets. whitepaper // page 18

19 Author biographies Darwei Kung Kung, a portfolio manager, manages the commodities portion of DWS Enhanced Commodity Securities Fund. With a total of 10 years of investment industry experience, he has extensive experience in risk modeling and quantitative trading. He received a bachelor s degree in computational finance and a master s degree in electrical engineering from the University of Washington, as well as a master s degree in business administration from Carnegie Mellon University. William Chepolis Chepolis, CFA, a portfolio manager, manages the fixed-income portion of DWS Enhanced Commodity Securities Fund. He joined the firm in With a total of 25 years of investment industry experience, he has extensive experience managing derivative investments and fixed-income assets. He received a bachelor s degree from the University of Minnesota. Jonathan Diorio Diorio, a senior portfolio specialist, covers commodities for DWS Investments. He joined the company in 2002 and served as head of DWS Investments' closed-end mutual fund business before moving into the role of portfolio specialist. He received a bachelor s degree in business from Loyola University and a master s degree in business administration from New York University s Stern School of Business. whitepaper // page 19