Commodities and Gold: Optimal Diversification or Unrewarding Risks? A retail perspective

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Acknowledgement

I would take this opportunity to thank my research supervisor, family and friends for their support and guidance without which this research would not have been possible.

DECLARATION

I, [type your full first names and surname here], declare that the contents of this dissertation/thesis represent my own unaided work, and that the dissertation/thesis has not previously been submitted for academic examination towards any qualification. Furthermore, it represents my own opinions and not necessarily those of the University.

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Abstract

In this study we try to explore the concept of “Optimal Portfolio” in a holistic context. The main focus of the research is on “the commodity assets” that are and its relation with “the return the investor is getting from his or her portfolio”. The research also analyzes many aspects of “alternative Investments” and tries to gauge its effect on “the return that the investor will be receiving”.

Table of Contents

CHAPTER 1: INTRODUCTION6

Introduction6

Background of the Study12

Research Aims and Objectives14

CHAPTER 2: LITERATURE REVIEW16

Index Investment and Financialization of Commodities16

Investments in commodity derivatives18

Gold at the core of a portfolio20

Strategic Asset Allocation and the Role of Alternative Investments25

Principles Of International Portfolio Investment29

CHAPTER 3: DATA SET AND METHODOLOGY34

CHAPTER 4: RESULTS AND ANALYSIS38

Regression Analysis41

SP-GSCI Index Return41

Investments in Gold46

Investment in Physical Gold46

Buying Gold Pool Accounts46

Investing in Gold Futures47

Buying Gold Backed Securities and Xetra - Gold49

Analysis of Gold as a Commodity50

CHAPTER 5: CONCLUSION AND RECOMMENDATION54

REFERENCES56

APPENDIX63

CHAPTER 1: INTRODUCTION

Introduction

Investments in commodities have grown rapidly over the last years mainly via commodity futures and commodity index funds. It is estimated that “inflows into commodity investments during 2009 will be a record $60 billion, topping $51 billion from 2006” (Wall Street Journal, January 4, 2010) with the prospect being that they will increase further. Furthermore, Stoll and Whaley (2010) estimate the total commodity index investment in the US to be about $174 billion in 2009. The common perception is that the popularity of investing in commodities lies in the fact that, from a theoretical point of view, commodities form an alternative asset class; their returns are expected to show small or even negative correlation with the returns of assets that belong to traditional asset classes like stocks and bonds.

This is because the factors that drive commodity prices (e.g., weather and geopolitical conditions, supply constraints in the physical production, and event risk) are distinct from those that determine the value of stocks and bonds. Moreover, in contrast with stocks and bonds, commodities serve as an inflation hedge (e.g., Bodie, 1983).

In fact, a number of empirical studies confirm this type of correlation over certain periods of time. Consequently, diversification benefits, i.e. reduction of risk for any given level of expected return, may emerge. However, there is evidence that the growing presence of index funds in commodities markets integrates the commodity markets with the stock and bond markets. This calls into question the diversification benefits of commodities. This paper revisits the common perception on the diversification role of commodities by investigating the benefits of investing in commodities in a more general setting than ...