Commodities in a Traditional Investment Portfolio Timothy J. Rudderow Friday, 4 March 2005

2 Commodities are HOT Search for non-correlated return Adding commodities to investment portfolios has gained traction Accessible commodity index products have simplified the analysis

3 Question #1 “In each of the other asset classes in my portfolio, I understand the economic risk premium I earn when I make the investment. It helps me form ideas about expected return and risk.” What is the economic risk premium in a commodities investment?

4 “If I add a commodities investment to my portfolio, what is the impact?” Can I make a difference? Leverage? Does the volatility help or hurt the portfolio? Will I lose my job? Question #2

5 Risk Premium: Motivation Past performance is not necessarily indicative of future results.

6 Risk Premium Risk Premium arguments look to the futures markets Futures markets exist to allow commercial interests to reduce price and rate risk Logical that the eventual holder of that risk earns a risk premium Challenge is in the measurement – an Index Must be passive and price based Must be able to replicate in the market

7 Hedging Today CHINA Global Bonds $$ $$ Products Raw Materials $$

8 Risk Premium: Method #1 Keynes: Normal Backwardation Futures trade at a discount to spot to compensate the risk bearer Son of Keynes: Goldman Sachs Commodity Index Younger Sibling: DJAIG Commodity Index Index construction Long a basket of commodity futures Market weights based on production

9 Method #1 Components of return Change in the price of the spot commodity Normal backwardation premium (or discount) in the futures price Risk Free interest rate Most bang in rising commodity environments Best in non-storable markets

10 Method #2 Background My bias: Full disclosure “What is the Benchmark?” Market Realities Hedgers on both sides of the markets Specs are long and short, too Volatility represents risk to business interests Back to the wheat chart

11 MLM Index™ Construction Recently “modernized” 22 futures markets Volatility Weighted Baskets Unleveraged Rebalanced monthly Positions can be long or short Transparent

12 Method #2 Components of return Gains from long and short positions Risk free rate of interest Performance Does well in sharply rising or falling markets Does poorly when markets are in equilibrium Broadens the risk premium argument to the full range of markets – all futures

13 Side Thought: Alpha and Beta Sources: CTA is the CSIDM/MAR CTA Index, Jan-92 thru Dec-04 ( CSFB is the CSFB Managed Futures Index, Jan-94 thru Dec-04 ( MLM is the simulated modernized MLM Index™ S&P 500MLM Index™ AlphaBetaAlphaBeta MAR CTA Index0.83% %1.34 t-stat CSFB HF Index0.77% %1.48 t-stat Past performance is not necessarily indicative of future results.

14 Return Summary Jan-1992 to Dec- 2004GSCI DJ-AIG Commod. Index MLM Index™ Pre-Modernized MLM Index™S&P 500 LB Aggregate Bond Zurich CTA Index 1 Year17.3%9.1%5.7%3.5%10.9%4.2%4.4% 3 Years87.0%70.3%21.3%5.8%11.1%19.6%32.4% 5 Years90.6%80.7%38.2%27.5%-11.0%44.8%46.5% Inception To Date130.3%169.0%168.8%139.9%275.0%140.5%215.8% Annual Return6.6%7.9% 7.0%10.7%7.0%9.2% Standard Deviation19.9%13.0%4.1%6.6%15.9%4.1%9.9% Sharpe Ratio Correlation w/S&P Past performance is not necessarily indicative of future results.

15 Relationship with other Assets MLM Index ™ Pre- Modernized MLM Index ™ CTA Index S&P 500GSCI DJ-AIG Commod. Index LB Aggregate BondCPI MLM Index™1.00 Pre-Modernized MLM Index™ CTA Index S&P GSCI DJ-AIG LB Agg. Bond CPI Past performance is not necessarily indicative of future results.

16 Why a Risk Premium? Inelasticity of the underlying markets Makes commercial markets different than equity markets It’s the reason businesses hedge Competition for capital Without a risk premium, futures markets become a casino – no reason to play Premium should be competitive with other capital markets.

17 Question #2: Portfolio Impact The Holy Grail Positive return Mark to Market An measurable economic risk premium No correlation with traditional assets COMMODITIES

18 Motivation: Volatility is Your Friend Past performance is not necessarily indicative of future results.

19 Asset Class Returns Past performance is not necessarily indicative of future results.

20 Asset Class Returns Past performance is not necessarily indicative of future results.

21 Baseline Portfolio Past performance is not necessarily indicative of future results.

22 Adding GSCI Past performance is not necessarily indicative of future results.

23 Adding MLM Index™ Effects on Efficient Frontier by Adding Futures to a Mix of Stocks and Bonds 8% 10% 12% 14% 16% 18% 20% 4%6%8%10%12%14%16%18%20%22% Standard Deviation Compound Annual Return Large & Small Caps, LT Govt, LT Corp & Junk With GSCI With MLM Period Jan Dec % Large Cap 50% Small Cap 0% LT Govt 0% Junk Bonds 0% LT Corp 0% Large Cap 0% Small Cap 33.3% LT Govt 33.3% Junk Bonds 33.3% LT Corp 20% Large Cap 20% Small Cap 20% LT Govt 20% Junk Bonds 20% LT Corp 0% Large Cap 0% Small Cap 0% LT Govt 0% Junk Bonds 0% LT Corp 100% GSCI 0% Large Cap 0% Small Cap 0% LT Govt 0% Junk Bonds 0% LT Corp 100% MLM 1X 8% Large Cap 8% Small Cap 8% LT Govt 8% Junk Bonds 8% LT Corp 60% MLM 1X Past performance is not necessarily indicative of future results.

24 Adding Leverage Past performance is not necessarily indicative of future results.