This "double real"™ strategy typically employs swap agreements to gain exposure to changes in a broad index of commodity futures prices, using portfolio assets as collateral. Such commodity indices typically include a rate of return on the underlying collateral that is roughly equivalent with money market rates.

 

PIMCO seeks to invest the portfolio assets that serve as collateral in predominately inflation-linked bonds (TIPS), which offer returns measured in real, not nominal, terms. If these fixed income investments provide a higher return than the rate embedded in a commodity index, the total return of the overall portfolio should be enhanced by the difference between these two rates. Economically, this "double real™" portfolio provides real returns in the form of income from the commodity index exposure and consistent real return income from the inflation-indexed securities.

 

The enhanced index approach capitalizes on two of PIMCO's core strengths: efficient management of derivatives positions and effective management of fixed-income securities. As one of the largest participants in the fixed income market, PIMCO has developed the resources, analytics and substantial experience to effectively manage positions in real return securities. PIMCO was an early leader in recognizing the value of inflation-indexed securities, and remains among the largest in the TIPS market. In addition, PIMCO has a history and a specialized staff with extensive experience and expertise in commodity index-linked derivatives.

 

The Return Benefits of a Broad Commodity Index

For separate account assignments, PIMCO can track any investable commodity index. PIMCO's CommodityRealReturn Strategy seeks to match the Dow Jones AIG Commodity Index. The DJ-AIG Commodity Index reflects changes in a broad range of commodity futures prices, from crude oil and coffee to gold and cattle.

 

The DJ-AIG Index offers the added benefit of re-balancing on a price percentage basis. This means that as the price of a particular commodity rises, it is effectively "sold" to bring the exposure to that commodity back to the target price percentage level, which is adjusted once a year (see table below for weightings as of March 2006). This is important because commodity prices tend to revert to an equilibrium level, rising or falling to meet changes in demand and then reversing course when supply responds to the change in price, as it ultimately does.

 

Components of Dow Jones-AIG Commodity Index As of March 31, 2006
Energy	30%	Natural Gas	9%
		Crude Oil	13%
		Unleaded Gas	4%
		Heating Oil	4%
Livestock	9%	Live Cattle	5%
		Lean Hogs	4%
Grains	19%	Wheat	5%
		Corn	6%
		Soybeans	7%
Industrial Metals	21%	Aluminum	7%
		Copper	7%
		Zinc	4%
		Nickel	3%
Precious Metals	9%	Gold	7%
		Silver	3%
Food/Fiber	9%	Sugar	4%
		Cotton	3%
		Coffee	3%
Vegetable Oil	3%	Soybean Oil	3%

Source: AIG

 

For example, a sustained rise in the price of oil makes it worthwhile to produce more oil. By re-balancing, the index would "sell" oil as the cost exceeded its given price percentage and "buy" oil once prices decline in response to the increase in production. As long as the price of all or most of the commodities in the index do not rise and fall in unison, price re-weighting should produce positive returns even if the price of commodities as an asset class drifts sideways.

 

The Benefits of Commodity Exposure

Since long-term inflation rates are highly unpredictable, it is difficult to protect the real value of portfolios through traditional investments in equities and non-inflation indexed bonds. Equities—even those of commodity producers—can be affected by external factors such as the financial structure of the company, management talent, or trends and valuation in the overall stock market. All of these factors may decrease the link between portfolio returns and the rate of inflation.

 

Commodities, however, tend to respond directly to changes in the economy that tend to produce inflation. For example, an increase in demand for finished goods and services that puts upward pressure on consumer prices will likely be accompanied by rising demand for the raw material commodities that go into producing goods and services, such as energy or metals.

 

In addition, commodity returns have historically demonstrated little correlation with returns from either stocks or nominal bonds, meaning commodities tend not to move in tandem with these more-traditional asset classes. This is largely attributable to the fact that rising inflation tends to result in higher interest rates, because inflation erodes the value of investments that pay a fixed rate of return. And an environment of rising inflation and rising interest rates is typically not favorable for equities. The lack of correlation between commodities and more traditional asset classes can help improve portfolio diversity.

 

Commodities can also act as a hedge against unforeseen developments. War, weather and other events can suddenly and unexpectedly affect commodity futures prices differently than they affect stock or bond prices.

 

Conclusion

Commodities and commodity index investments can offer investors a number of benefits. Since commodities are well correlated with inflation, but non-correlated with traditional asset classes such as stocks and bonds, exposure to a broad commodity index should improve a portfolio's long term real-return potential and increasing diversification, which tends to reduce risk.

 

PIMCO's enhanced-index approach to commodity investing relies on our core abilities as a bond manager: effective fixed income management and efficient management of derivatives positions. Both are critical to success in this area. In addition, broad commodity indices offer return potential even in the absence of a general uptrend in commodity prices, because of the benefits of index rebalancing.