(John Kemp is a Reuters market analyst. The views expressed are
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
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
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
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
But Lombardi and Ravazzolo find common macro factors rather
than market-specific fundamentals may have become more
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
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
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
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
(Editing by Keiron Henderson)