(John Kemp is a Reuters market analyst. The views expressed are his own)
By John Kemp
LONDON, July 24 Commodities do not diversify an investment portfolio, according to new research by the Bank for International Settlements (BIS), overturning conventional wisdom that including commodity futures can reduce the volatility of returns.
Beginning in September 2008 and continuing through 2012, commodity and equity prices have shown heightened correlation, Marco Lombardi and Francesco Ravazzolo argue in a paper "On the correlation between commodity and equity returns" published on July 11 (www.bis.org/publ/work420.pdf).
"Both (are) apparently more sensitive to news concerning the global macroeconomic environment rather than idiosyncratic and market-specific shocks," the authors observe.
As a result "the popular view that commodities are to be included in one's portfolio as a hedging device is not grounded."
According to the authors, including commodities alongside equities in an actively managed portfolio can boost returns -- but only if the portfolio manager correctly predicts the direction of both markets.
"The growing appetite for commodities is likely to produce more volatile portfolios," Lombardi and Ravazzolo conclude.
DIVERSIFICATION NO MORE
The paper is part of a widespread reassessment in the academic community about how commodity prices behave.
The BIS report contradicts earlier research which found a negative correlation between the returns on equities and commodities -- and argued commodities should be included in a balanced portfolio to improve diversification without affecting risk-adjusted returns.
In their now famous paper on "Facts and Fantasies about Commodity Futures," which helped popularise commodity investing, academics Gary Gorton and Geert Rouwenhorst identified a negative correlation between the returns on equities and commodities between 1959 and 2004.
"The historical performance of collateralised investments in commodity futures suggests that they are an attractive asset class to diversify traditional portfolios of stocks and bonds," Gorton and Rouwenhorst wrote in 2004.
Lombardi and Ravazzolo found that is no longer the case, at least not since the eruption of the financial crisis.
IT'S THE ECONOMY, STUPID
The BIS paper also confirms that the factors driving commodity prices have changed: commodities have indeed become more "financialised," as a number of others have pointed out.
Gorton and Rouwenhorst reported "the negative correlation between commodity futures and other asset classes is due, in significant part, to different behaviour over the business cycle."
But Lombardi and Ravazzolo find common macro factors rather than market-specific fundamentals may have become more influential.
According to the BIS researchers, one explanation may be the growing role of financial investors in commodity markets alongside traditional producers, consumers and merchants.
"Financial investors may have less commodity-specific knowledge and a different attitude compared to (traditional) commercial players, and hence enter or exit trades based on their overall perceptions of the macroeconomic situation rather than market-specific factors," Lombardi and Ravazzolo observe.
"If this is the case, it would suggest that commodity prices are increasingly influenced by shocks coming from the demand side. This is a well-established fact in the literature on oil."
"The fact that equity prices are also likely to have been largely driven by shocks related to the global economic activity, especially in the aftermath of the financial crisis, could then explain the increase in correlations," they find.
Commentators have indeed often pointed at commodity and equity prices moving in the same direction as a consequence of more optimistic or more pessimistic expectations about the global economy.
PORTFOLIO MANAGER SKILL
Ironically, Lombardi and Ravazzolo have published their paper just as the correlations between different commodity prices, and with equities, have started to weaken. Now that the Great Recession and Great Reflation have played out, market-specific fundamentals are reasserting their importance.
Nonetheless, the paper is an important contribution to a corpus of new work being published on the formation and behaviour of commodity prices which enriches and challenges traditional theories.
It provides more evidence that prices are driven by both market-specific fundamentals and a broader set of financial factors, which include the risk-on risk-off trade, momentum, speculation and behavioural influences.
Many traditional commodity researchers have resisted any attempt to link prices with "speculation" for fear that the admission would encourage policymakers to intervene.
But as Lombardi and Ravazzolo show, the evidence for speculative and macro factors is now overwhelming and widely accepted. The fundamentals-only view, while politically and financially convenient, is no longer credible.
Their paper also suggests investors cannot rely on a passive "buy and hold" approach. Rather, commodity holdings must be actively managed, if the hoped for benefits in terms of returns and diversification are to be realised.
As the authors explain, if a portfolio manager can predict the direction of equity markets, and adjust their commodity exposure accordingly, it is possible to achieve superior returns. That is a big "if".
The paper also reinforces another point becoming widely accepted. Most if not all the returns from investing in commodities come from the (active) skill of the portfolio manager rather than the (passive) properties of commodity derivatives themselves.
If there were once significant returns to a buy-and-hold strategy, they have long since disappeared as investing in commodity derivatives has become more popular and the market has become increasingly crowded.
It is wrong to think of commodity derivatives as an "asset class". Rather they are a specialised risk transfer instrument that can offer high returns, but only to those with specialist knowledge. (Editing by Keiron Henderson)
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