Commods lose diversification edge with crisis

By Barani Krishnan and Jennifer Ablan - Analysis

NEW YORK (Reuters) - Using commodities to hedge potential losses in stock markets has not worked lately, and the tighter link among assets these days means diversification benefits may not be as great as before.

Hedge funds, pension funds, mutual funds and wealthy individuals who invested in commodities on the theory that they move independently of other asset classes watched helplessly as the global economic nosedive turned commodities, once the top asset class, into the year's worst performer after equities.

Those who have studied commodities and longtime investors in energy, metals and grains say that in ordinary times, these markets make good alternatives to stocks.

But these are not ordinary times.

"This is the worst I've seen in my 10 years in the business," said Rian Akey, chief operating officer at Cole Partners, a Chicago fund manager that invests in commodity hedge funds.

"The theory of diversifying into commodities has relied on all things being different to stocks, i.e. different fundamentals, different pricing issues, different asset classes, etc.," Akey said. "All that goes away when people are selling everything, no matter what, to raise cash. Then, you have high correlation, instead of non-correlation."

Until June, commodities were the best performing asset class for four straight quarters as easy credit, booming growth in giant developing economies like India, China, Russia and Brazil and surging inflation sent prices of oil, gold, copper, corn and other resources to record highs.

The Reuters-Jefferies CRB Index , a global commodities benchmark, saw its best gains in 35 years in the second quarter, returning 33 percent. Now, it is down that much for the whole year. The only worse performer is the MSCI All-World Index -- a stocks benchmark for institutional investors -- which is down 48 percent.

Akey, who wrote a paper in 2005 that showcased commodities as an effective risk-adjusted return source and portfolio hedge, said the credit crisis has shown the asset class is not the antithesis of stocks as many believed.

"In a negative equity environment, you have the potential to make money in commodities. But it can be damaging if people put too much reliance upon commodities as an equity hedge because you can also lose money during down periods in equities as well," he said.

"The current environment is characterized by deleveraging and clearly, fundamentals are not the driver. I don't think in the short-term you're going to see diversification being highly beneficial for anybody," Akey said.

Brian Hicks, co-manager of a resources fund at U.S. Global Investors, summed up a similar feeling when commenting recently on how commodities and equities had tacked on to each other on their way down. "There is nowhere to hide," he said.

The situation was different as recently as July when U.S. crude oil hit record highs above $147 a barrel while the S&P500 U.S. stock index was down 15 percent on the year. Even when commodities rallied broadly in July, some markets like cotton and sugar fell on their own fundamentals.

Yale professors Geert Rouwenhorst and Gary Gorton in 2004 popularized the theory that commodities did not correlate with other asset classes. They published a study comparing annualized monthly returns from commodities with those of stocks, bonds and U.S. Treasury bills between July 1959 and March 2004.

The professors did not respond to e-mails from Reuters, requesting comment on that paper -- entitled "Facts and Fantasies about Commodity Futures" -- and its relevance to the credit crisis.