Real Alternative Asset Classes

He told me he always kept his customers informed, and the bank he worked for was uniformly satisfied with the bank's approach. The calls were regarded as an insurance policy to protect its fixed-asset investment and were happy to pay the premiums while feeling fortunate that the bank never had a claim. I thought that both the banker and his clients were correct and he had indeed purchased a cheap and prudent insurance policy for them over the years.

Then I spoke with an American portfolio manager and asked him if he ever applied the same technique. He told me that not only did he not do so, but no one he knew did. Why? Bond departments were far removed from commodity departments. Many money managers such as banks or insurance companies do not even have commodities departments, he told me. In many other countries, it is not uncommon for the commodities department to interface with the fixed-income department.

The American portfolio manager then said it was common in actively managed fixed-income departments in investment companies and hedge funds to also trade in bond futures and options, and added that there was a substantial difference. Precious metals really protect against fixed-income risk while selling bond futures or options. Metals, he explained, actually act to reduce or increase the effective size of the portfolio by insuring it against substantial risk.

There are many alternative asset classes, and we use very few of them. It would hold us in good stead to consider more of them.

Diversification

Everyone talks about diversification of asset classes, and money managers even try to do it in balanced portfolios. Further, we all know that just owning IBM and Cisco does not provide the diversification we need. We try to diversify by owning bonds as well as stock; owning small, midsized and large companies; and by owning different funds, some of which some are value oriented, while others are focused on growth.

A more sophisticated approach to true diversification would involve hedge funds or commodities accounts. However, this is not real diversification. If that's what you choose to do, all you are doing is investing in a trading operation that you hope will continue to generate absolute positive returns, irrespective of market direction. If that's what you are doing, you are betting on the skills of a market prognosticator or a trader. You hope that their agility and timing are better than your market timing and trading skills.

Commodity index funds

Several sophisticated investment managers have set up commodity index or quasi-index funds to offer exposure to physical commodities. Investment banker Jimmy Rodgers has set up such a fund that has done very well, what with the general price rise in commodities; in addition, both Goldman Sachs and Pimco offer similar funds.

Simply, the index funds are a bet that commodity prices will rise. They offer an alternative asset class, which may or may not complement your portfolio. All these funds contain substantial fees, which can undermine performance in the long run.

Levels of risk

Each investor may seek different risk levels in different asset classes. One investor may be very comfortable in purchasing out-of-the-money puts and calls, for very small sums of money, and be content when they expire worthless. Another investor may regard out-of-the-money options as being expensive and having relatively little value. He might prefer to invest more money and purchase futures or the physical commodity. Although this involves much more money, it would nonetheless provide greater value.

With precious metals, many investors simply buy the most current month and take physical delivery of the warehouse receipt. Each month, for a small charge, the investors know that they own the physical commodity and can sell the commodity at any time on the exchange. The bonded warehouse receipt can then be delivered against the contract that they sell. Most regard this as a long-term investment and simply continue to hold the commodity in the warehouse as a form of investment.

It is fairly cheap to buy a futures contract and take delivery of the bonded warehouse receipt. The market is very fluid and you simply sell the contract on an exchange. By definition, the delivery receipts are readily marketable and come in the same uniform size as the futures contracts.

On the New York Commodities Exchange (COMEX), a gold contract is 100 ounces or at $385/ounce the equivalent of $38,500 a silver contract is 5,000 ounces or at $5.10/ounce, the equivalent of $25,500. It should be noted that emini contracts are traded on both gold and silver and they allow you to take delivery. The gold emini contract is for 33.3 ounces or $12,820, while the silver emini contract is only 1,000 ounces or $5,100.

Customized diversification

The reality of life is that different people have different needs. Financial exposure encompasses more than a portfolio; it affects the person's entire life. Real asset class diversification can be customized to meet an individual's specific risk.

Here's an example. A young couple buying a new home and taking on a variable-rate mortgage loan might consider buying out-of-the-money bond puts in the event there is a dramatic rise in interest rates. They are not afraid of small fluctuations, but they want to be protected in the event of a large rise in interest rates.

As another example, a retired couple with a large municipal bond portfolio might consider a combination of owning some precious metal warehouse receipts and at the same time using a small portion of their interest stream to purchase out-of-the-money gold calls. Concurrently or as an alternative, they might short the US Dollar Index (traded on FINEX in New York) or simply buy calls on the euro or yen.

Yet another example, a businessman concerned about rising commercial prices might simply buy wheat, cotton, and copper futures and continually roll over the contracts. This is a diversified portfolio.

Over the years, fewer investors have been taking long-term positions in commodities. It has become the domain of traders and hedge funds.

Many brokerage firms have no commodities department, and those that do keep it separate from their equity and bond departments. The financial advisors (previously known as account executives) who advise you on your stocks and bonds would never think (and is probably not licensed) to recommend and execute commodity transactions on your behalf.

Conclusion

Passive investment in commodity futures should be utilized as a means of providing real asset allocation and reduction of portfolio risk. It is not difficult or expensive to accomplish. Once made, your positions need not be engraved in stone, but they can be modified or tweaked as conditions change. It is a valuable tool that should be used by all.

Robert L. Lewis is an attorney practicing in New York City and a member of several commodity and stock exchanges.

Current and past articles from Working Money, The Investors' Magazine, can be found at Working-Money.com.