Commodities: No Longer an Asset Class in their Own Right?*

Investors, seeking to diversify their portfolio and hedge against rising inflation, have increased their exposure to commodities by directly purchasing commodities, by taking outright positions in commodity futures, or by acquiring stakes in exchange-traded commodity funds (ETFs) and in commodity index funds. This pattern has accelerated in recent years. According to index investment data collected by Barclays Capital for US and non-US assets under management, commodity index investment has increased from $55 billion in late 2004 to $431 billion in July 2011.

 The initial surge in investment in commodities is due to the observed negative correlation between commodity returns and the other asset returns as well as positive correlation between inflation and commodity returns.

Although the positive correlation between inflation and commodity returns (0.55 for the last twenty years and 0.73 for the last three years in monthly inflation and commodity returns proxied by returns on S&P Goldman Sachs commodity total return index) is still present, the recent positive correlation between commodities and the other asset classes raise the question of whether commodities can still be considered as an asset class in their own right, and particularly a route to portfolio diversification.

A commonly used approach is to consider an investment as a separate asset class when:

•  Its expected returns are higher than risk-free returns;
•  Its returns perform differently from other asset classes in any given market environment; and
•  Its returns may not be replicated with a linear combination of other asset classes.

Up until Lehman Brothers’ demise in September 2008, commodities met all three criteria. However, since then, commodities have not displayed the last two characteristics of an asset class. Of course, there are episodes in history when commodities moved in sync with other assets, especially equities. Nevertheless, compared to other episodes in the last two decades, the last three years have seen different dynamics in their degree and duration.

Between September 1991 and September 2008, weekly returns on commodities proxied by Goldman Sachs commodity index were very close to equity returns and exceeded bond returns and risk-free Treasury-bill returns. They displayed negative correlation with stocks (-0.008) and bonds (-0.008) (as shown in the upper triangle of the correlation table). However, since September 2008, commodity returns registered negative returns as well as statistically significant positive correlation with equities (0.689) and bonds (0.022) (as shown in the lower triangle of correlation table) returns.

Furthermore, if we regress the weekly GSCI return on weekly stock returns for the two sub-periods considered above, then these regression analyses suggest that the variation in commodity returns is independent of either stock or bond returns between September 1991 and September 2008 – but not afterwards. Specifically, the regression results after Lehman’s demise suggest that more than 47% of the variation in commodity returns can be explained by variation in stock returns. The statistically significant coefficient on stock returns suggests that a 1% increase in stocks returns leads to 0.85% increase in commodity returns. Additionally, when we regress weekly GSCI energy returns on stock returns, we find a statistically higher coefficient on stock returns, revealing that a 1% increase in stocks returns leads to a 1% increase  in energy-commodity returns.  These findings suggest that post-Lehman commodity returns might be replicated by returns on stocks. In this sense, one may conclude that commodities in the last three years do not appear to fulfil the three criteria  to be considered as a separate asset class in their own right.

As we argued earlier, the recent episode of high correlation between different assets may not be unique, and it is unclear whether the change observed between asset classes’ movement, or more specifically commodity prices, are permanent. Several recent academic studies suggest that the financialisation of commodity markets has increased the co-movements between equities and commodities. If these studies’ findings are any guide, we may well expect that co-movements between commodities and equities are here to stay as long as investors’ appetite for commodities stay strong.

*IEA Oil Market Report-October 2011