Commodities are the necessary building blocks of the world. Glance around you—commodities are what the world needs to live and prosper and are everywhere you look. The world’s seven billion people need resources, and that’s why we recommend investors consistently allocate a portion of their portfolio to a natural resources investment.

Not every investment is the same, though. Even within the commodities space, when looking at measures such as correlation, performance and risk, two indexes can have very different effects on a portfolio’s results.

Take two popular commodity-related indices for example, the Dow Jones-UBS Commodity Index (DJUBS) and the Morgan Stanley Commodity Related Index (CRX).

The DJUBS is made of futures contracts on various physical commodities that represent major commodity sectors such as agriculture, energy, grains, metals, livestock and precious metals. Basically, futures are contracts between a buyer and seller, where the buyer agrees to purchase a specific commodity for a specific price and specific time in the future.

The CRX is comprised of stocks involved in commodity related industries, such as energy, non-ferrous metals, agriculture and forest products.

Yet, while both indices are diversified across various commodities, their correlations to the overall market differ.

Take a look at the matrix looking at 10 years of data. The table lists the S&P 500 Index, which represents the overall U.S. stock market, and the two commodity indices. When two asset classes or investments are perfectly correlated to each other, their performance moves are in sync and they have a correlation of 1; 0 means that the two investments have no correlation to each other.

Over the past decade through June 30, 2012, you can see the DJUBS and the S&P 500 have had a correlation of 0.80. The CRX and the S&P 500 had a correlation of 0.62. This means the CRX is less correlated to the overall market than the DJUBS.

And why is a low correlation beneficial? In a diversified portfolio, it can reduce an investor’s volatility.

In the article “Material World,” Financial Planning found that a low correlation is a “valuable feature” for natural resources mutual funds. When author Craig Israelsen compared the correlation to the overall market to the 10-year annualized returns of 18 natural resources funds with 10 years of performance records, “a clear pattern” emerged. “Natural resources funds with lower correlations (that is, closer to zero) had better performances during this span,” he says.

See the article now.

Over the past 10 years, this pattern was prevalent in the CRX, as commodity producers far outperformed the index of commodity futures.

How to Optimize Your Portfolio with Commodities

So how do correlations and long-term performance translate to your portfolio? One way to look at this would be to create an efficient frontier, which charts a range of allocations to commodities and the overall market to see which portfolio would be most efficient, i.e., which portfolio enhances returns without adding risk.

To find the optimal portfolio between commodities and the overall market, the efficient frontier plots different portfolios, ranging from a 100 percent allocation to an investment in the S&P 500 and gradually increasing the percentage of commodities. Each dot along the path of the efficient frontier represents an incremental increase toward a 100 percent allocation to commodities investment.

First, we chart the efficient frontier of the DJUBS and the S&P 500. A 100 percent allocation to the S&P 500 would result in a portfolio achieving a 5.9 percent return and 20.3 percent annualized volatility.

Assuming the portfolio was rebalanced each quarter, our research found that a portfolio holding 25 percent allocation to the commodities futures and 75 percent allocation to an investment in U.S. equities would decrease an investor’s return by about 0.17 percent while decreasing volatility by a little more than 3 percent. Simply, the addition of commodity futures yields less volatility for about the same return.

A different picture emerges when you chart an efficient frontier for a portfolio invested in commodity equities and the overall market. In a portfolio of 25 percent commodity equities and 75 percent U.S. stocks, an investor reduces their risk by almost 1 percent while increasing their return by nearly 1.5 percent.

How Resourceful Is Your Portfolio?

The charts above illustrate how the power of commodities enhances a portfolio, although a 25 percent allocation may be a little too aggressive. For reference, about 15 percent of the S&P 500 Index is made up of energy and materials companies.

The Global Resources Fund (PSPFX) uses the CRX as its benchmark, and we’re pleased to say that over the past 10 years, the four-star fund* has outperformed its benchmark, resulting in even greater returns for shareholders.

Put commodities to work in your portfolio today.

* The Global Resources Fund earned a 4-star Morningstar Overall Rating™ among 121 natural resources funds as of 8/31/2012. The Global Resources Fund earned a 3-star Morningstar Overall Rating™ among 124 natural resources funds as of 6/30/2012.

Please consider carefully a fund’s investment objectives, risks, charges and expenses. For this and other important information, obtain a fund prospectus by visiting www.usfunds.com or by calling 1-800-US-FUNDS (1-800-873-8637). Read it carefully before investing. Distributed by U.S. Global Brokerage, Inc.

Foreign and emerging market investing involves special risks such as currency fluctuation and less public disclosure, as well as economic and political risk. Because the Global Resources Fund concentrates its investments in a specific industry, the fund may be subject to greater risks and fluctuations than a portfolio representing a broader range of industries.

Morningstar Ratings are based on risk-adjusted return. The Overall Morningstar Rating for a fund is derived from a weighted-average of the performance figures associated with its three-, five- and ten-year (if applicable) Morningstar Rating metrics. Past performance does not guarantee future results. For each fund with at least a three-year history, Morningstar calculates a Morningstar Rating based on a Morningstar Risk-Adjusted Return measure that accounts for variation in a fund’s monthly performance (including the effects of sales charges, loads, and redemption fees), placing more emphasis on downward variations and rewarding consistent performance. The top 10% of funds in each category receive 5 stars, the next 22.5% receive 4 stars, the next 35% receive 3 stars, the next 22.5% receive 2 stars and the bottom 10% receive 1 star. (Each share class is counted as a fraction of one fund within this scale and rated separately, which may cause slight variations in the distribution percentages.)

The Morgan Stanley Commodity Related Index (CRX) is an equal-dollar weighted index of 20 stocks involved in commodity related industries such as energy, non-ferrous metals, agriculture, and forest products. The index was developed with a base value of 200 as of March 15, 1996. The S&P 500 Stock Index is a widely recognized capitalization-weighted index of 500 common stock prices in U.S. companies. The Dow Jones UBS Commodity Index is composed of futures contracts on physical commodities, and includes commodities traded on U.S. exchanges, with the exception of aluminum, nickel and zinc, which trade on the London Metal Exchange (LME). Diversification does not protect an investor from market risks and does not assure a profit.

The world watched in awe as American swimmer Michael Phelps became the most decorated Olympian of all time. I’ve read he’s been training in the pool for an average of 6 hours a day, 6 days per week, which equates to about 30,000 hours since age 13 and about 10,000 calories burned during a training day. It’s inspiring to see the incredible results of his tremendous sacrifice and commitment.

Investing in global markets requires the same sort of stamina, especially at times like this week, when the month’s reading on the manufacturing industry was not encouraging. The J.P. Morgan Global Manufacturing PMI of 48.4 for July was the lowest since June 2009.

However, I believe there are encouraging pockets of strength to energize and inspire investors.

For example, we’re coming up on the anniversary of the first stimulus move that kicked off the global easing cycle. On August 31, 2011, Brazil unexpectedly cut rates by 50 basis points, and since then, ISI says 228 stimulative monetary and fiscal policy moves have been initiated across several countries, including the Philippines, China, France, and Colombia.

In June and July alone, there were nearly 70 moves—the most since the world began this massive easing.

Generally, by the time central banks make a fiscal or monetary easing move, economic deterioration has already occurred. Even with these moves, it still takes several months for the stimulative measures to take effect and work their way through.

But while the world wades in the shallow end of the pool waiting for the economy to warm up, Asia has taken a deep dive into the energy space as they’ve recently announced acquisitions of Canadian resources companies.

In my presentations, I’ve discussed how resources companies have significantly underperformed their underlying commodities. During 2009 and most of 2010, the performance between oil and the S&P 500 Oil & Gas Exploration and Production Index was closely correlated. By the middle of 2011, oil and oil stocks started to separate, with crude continuing to rise while stocks deteriorated. Even with the recent drop in oil prices, oil stocks have continued to lag.

I’ve also discussed the strikingly similar trend occurring between gold and gold stocks. There’s been a spectacular pop in gold stocks recently, but it hasn’t been enough to catch up to gold’s performance.

The disparities mean that the cheapest resources are not found in the ground—they’re listed, and it’s been confirmed by recent energy company acquisitions.

Chinese oil company CNOOC put in a bid of $15 billion to purchase Canada’s Nexen. This was at a 61 percent premium to Nexen’s share price on July 20, according to Bloomberg. As you can see below, not only did the takeout announcement close the gap, now the company is outperforming the price of oil.

If CNOOC’s deal is approved, the state-run oil giant gets even bigger, gaining access to significant energy stores in several areas of the world, including Canada, the Gulf of Mexico, Colombia and West Africa, as shown below.

With a rapidly growing middle class and rising urbanization, Chinese leaders know they need to fill their country’s tremendous energy demands and are continually finding innovative ways to keep their country powered. CNOOC’s acquisition is one way China continues to acquire not only the resources needed to power the country, but also the technological innovations that come from countries with free markets and lower barriers to entry. According to The New York Times, China “has been garnering advanced production technologies to better draw oil and gas from nontraditional areas like deepwater fields and hardened rock formations.”

The other announcement came from Malaysia’s state-owned and natural-gas giant Petronas, which will purchase Canada’s Progress Energy Resources Corp. Petronas is one of the largest producers and shippers of supercooled LNG fuel in the world. According to the Vancouver Sun, the company is “anxious to increase its market share in Asia, where analysts expect demand to surge 75 percent by the end of the decade.”

After Petronas’ original bid was announced, Progress increased 74 percent—a record gain for the company, says Bloomberg. As shown below, Progress now dramatically outperforms the underlying commodity.

Ready to be a Buyer like Asia?
If you’re contrarian investor, there may be an additional reason to jump into the market today. According to research from J.P. Morgan, institutional investors have become extremely negative, as hedge funds “essentially short the market,” meaning that their expectation is that stocks will fall. 

J.P. Morgan looked at the rolling 21-day beta of macro fund returns compared to the S&P 500 Index returns and found that the ratio is at an extreme level of -0.26. Research shows that the last two times the ratio fell this low—in September 2010 and February 2012—stocks rallied. In 2010, the S&P 500 climbed 26 percent in five months; in 2012, stocks rose 8 percent in two months.

These signs the market is sending out make it an especially attractive time to “mine” for investment opportunity. In July, we began to see energy stocks and oil get recharged, as the energy sector in the S&P 500 was the second best performer, increasing 4.17 percent and crude oil rose 3.68 percent. Unlike the start of an Olympic race, in investing, there isn’t a signal sounded to let you know when to dive off the starting block into the markets. Just make sure your portfolio is poised to participate in the race for resources.

All opinions expressed and data provided are subject to change without notice. Some of these opinions may not be appropriate to every investor.

The J.P. Morgan Global Purchasing Manager’s Index is an indicator of the economic health of the global manufacturing sector. The PMI index is based on five major indicators: new orders, inventory levels, production, supplier deliveries and the employment environment. The S&P 500 Oil & Gas Exploration & Production Index is a capitalization-weighted Index. The index is comprised of six stocks whose primary function is exploring for natural gas and oil resources on land or at sea. The NYSE Arca Gold Miners Index is a modified market capitalization weighted index comprised of publicly traded companies involved primarily in the mining for gold and silver. The S&P 500 Stock Index is a widely recognized capitalization-weighted index of 500 common stock prices in U.S. companies.

The following securities mentioned were held by one or more of U.S. Global Investors Funds as of 6/30/12: CNOOC, Progress Energy.

One of the few things that Barack Obama and Mitt Romney can agree on is that our economy is still struggling to regain its strength. Stubborn unemployment and sluggish growth at home combined with a slowing China and a dysfunctional eurozone have cast a dark shadow on America’s eternal optimism. The media favors negative news and the 24/7 cycle of gloom and doubt can be dispiriting.

We are always looking for the economic points of light around the globe and strive to provide a counterpoint to the pervasive pessimism. As Warren Buffett once said, “It’s never paid to bet against America. We come through things, but it’s not always a smooth ride.”

I moved from Toronto to San Antonio more than twenty years ago. A Canadian pursuing the American Dream. I bought a business that became U.S. Global Investors. I believed back then, as I still do today, that there is nowhere else in the world where opportunity abounds and initiative is rewarded as it is in the U.S.A. “Despite all its setbacks, the U.S. remains at the center of world competiveness because of its unique economic power, the dynamism of its enterprises and its capacity for innovation,” according to IMD, a well-regarded Swiss business school.

IMD recently released the findings of its annual World Competitiveness Yearbook (WCY). Its rankings survey more than 4,200 international executives and measure how well countries manage their economic and human resources to increase prosperity. The top three most competitive of the 59 ranked economies in 2012 are Hong Kong, the U.S. and Switzerland.

Barron’s editorial page editor Thomas G. Donlan wrote, “It’s worth contemplating the advantages that a group of international business executives and analysts still can find in the U.S. economy. At the top is access to financing, following a strong research-and-development culture, an effective legal environment, dynamism of the economy, a skilled workforce, and reliable infrastructure. At the bottom, they find the U.S. lacks competency of government and a competitive tax regime.”

During tough times, Americans must be vigilant in safeguarding our competitive edge by continuing to be a compassionate and generous nation while resisting the siren calls of socialism. A system that strangles private property rights and sponsors excessive bureaucracy, regulation and taxation cannot deliver on a promise of prosperity to its people. We must not lose our collective faith in capitalism because it has proven to be the only social system that rewards individual ability, initiative and achievement.

What Henry Ford said a century ago holds true today, “What's right about America is that although we have a mess of problems, we have great capacity—intellect and resources—to do something about them.”

The Economist’s cover story last week heralded America’s economy the “Comeback kid.” “Led by its inventive private sector, the economy is remaking itself. Old weaknesses are being remedied and new strengths discovered, with an agility that has much to teach stagnant Europe and dirigiste Asia,” according to the story.

The story notes that while America’s overall growth is unimpressive, some components show signs of boom. We have shifted from a consumption-driven economy to a more outward-facing one. In the post-recession economy exports contributed 43 percent of growth, one of the strongest showings in any recent economic recovery. While sales to traditional markets in the OECD have risen just 20 percent since the end of 2007, they are up 51 percent to Latin America and 53 percent to China.

According to The Economist, emerging markets have also reinvigorated America’s role as a big commodity producer. Grain exports are soaring, agricultural land values are rising, and higher oil prices have triggered new output. American innovation in discovering new techniques to release oil and gas from shale has paid massive dividends to the energy sector and created thousands of new jobs in the industry. I wrote about this employment boom recently in Frank Talk and we see this explosion of growth first-hand just south of San Antonio with the development of the Eagle Ford Shale.

Cheap, plentiful natural gas benefits industries as diverse as glass, fertilizers, plastic and steelmakers. Last year for the first time in decades, America became a net exporter of refined products. And our nation’s gap between oil consumption and domestic production is shrinking.

A way to take advantage of a potential upturn in commodities is by choosing dividend-paying global resources equities. In the S&P 500 Index, nearly all of the materials and utilities stocks and more than half of energy companies pay a dividend that is higher than the 10-year Treasury. Materials and utilities companies yield an average of 2.3 percent and 4.1 percent, respectively, while energy stocks pay an average yield of 2.2 percent. We like the combination of income with growth and it is an important factor in our stock selection process for the Global Resources Fund, as well as our other equity funds.

We believe there are many great American companies to invest in. We like those that are growing their top line revenues and paying robust dividends. Currently 47 percent of the S&P 500 stocks pay a dividend yielding more than a 10-year Treasury, demonstrating the resiliency and strength of American enterprises.

Professor Stephane Garelli, director of IMD’s World Competitiveness Center, said, “U.S. competiveness has a deep impact on the rest of the world because it is uniquely interacting with every economy, advanced or emerging. No other nation can exercise such a strong ‘pull effect’ on the word. In the end, if the U.S. competes, the world succeeds!”

It is the nature of humans to compete. The Summer Olympics commencing next week in London will bring together more than 10,500 athletes from 204 countries to compete for the gold. I look forward to watching this showcase of the human spirit and the drive to succeed.

Please consider carefully a fund’s investment objectives, risks, charges and expenses. For this and other important information, obtain a fund prospectus by visiting www.usfunds.com or by calling 1-800-US-FUNDS (1-800-873-8637). Read it carefully before investing. Distributed by U.S. Global Brokerage, Inc.

Foreign and emerging market investing involves special risks such as currency fluctuation and less public disclosure, as well as economic and political risk. Because the Global Resources Fund concentrates its investments in a specific industry, the fund may be subject to greater risks and fluctuations than a portfolio representing a broader range of industries.

All opinions expressed and data provided are subject to change without notice. Some of these opinions may not be appropriate to every investor. The S&P 500 Stock Index is a widely recognized capitalization-weighted index of 500 common stock prices in U.S. companies.