Portfolio Optimization with Commodities - Sub-Sector and Business Cycle Analysis:

University essay from Handelshögskolan i Stockholm/Institutionen för finansiell ekonomi

Abstract: Commodities have traditionally been viewed as good diversifiers in a portfolio of stocks and bonds. However, recent literature has challenged the alleged benefits of commodities and created a need for further research in this field. We update previous research on the role of commodities in a portfolio by studying the DJ-UBSCI and the GSCI during the period of 1991 to 2011, concluding that commodities still demonstrate equity-like returns. However, we find that commodity correlations with stocks and bonds have increased in recent years, indicating diminishing effects of diversification benefits. Additionally, we study the optimal portfolio allocation with commodities and suggest two different strategies to test strategic and tactical allocation. We reject the business cycle strategy and find that business cycle phases are a poor indicator for tactical allocation to commodities. However, we conclude that strategic allocation to commodities can be improved by using sub-sectors instead of a total commodity index. The optimal portfolio over the entire period using the sub-sector strategy consists of bonds, precious metals, stocks, industrial metals and energy in a descending order.

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