Asset AllocationOctober 28, 2013

Hermes: Commodities are Still a Diversifier

<em>Do commodities still have a future in an institutional portfolio after this year’s bad run? One asset manager thinks so.</em>

Reported by Featured Author

(October 28, 2013) – Commodity returns are once again decoupling from equities, displaying the diversification benefits they had shown before the financial crisis, according to Hermes.

The asset manager said that while investors were understandably disappointed with commodities positive correlation with equities during May and June this year, they shouldn’t abandon the asset class as a diversifier just yet.

Jason Lejonvarn, strategist at Hermes Commodities, wrote in a paper that historically, the positive correlation between equities and commodities has been low—averaging 0.2 between 1970 and 2013.

That figure spiked at 0.8 during the tapering tantrum of Q2 this year, driven by widespread “risk-on” and “risk-off” appetites, he said, along with central banks’ asset purchasing programmes and slower Chinese growth.

But today, the correlation is easing once again. “Commodity investors should not despair. The correlation between commodity and equity returns is significantly lower than monthly data since mid-2008 indicate,” he said.

“Lower correlations are already here. Looking at more frequent daily data, commodity and equity correlations peaked in the autumn of 2011. Since then, they have decreased from approximately 0.7 to 0.4. Meanwhile, commodity and bond returns have had consistently negative correlations.”

Other diversification indicators within the commodity asset class also continue to show positive signs, he continued. The average correlation between the five commodity sectors—energy, industrial metals, precious metals, agriculture, and livestock—have had little to zero correlation, enriching the diversification properties of the asset class.

“Daily returns show that inter-sector correlations peaked in late 2011 and have since declined from a high of 0.42 to 0.1. Commodities are reverting to their historically low inter-sector correlations,” he said.

Another diverse attribute of commodities is its relatively high cross-sectional volatility, rising recently from 15% to approximately 25%. If you’ve got the stomach for it, Lejonvarn said this volatility increase was indicative of positive active commodity returns.

“These recent trends indicate that the diversifying qualities of commodities are on the mend. Like other risky asset classes, commodities suffered high correlations with other risky assets after the financial crisis. However commodities are now reverting back to being a diverse, independent asset class,” he concluded.

Are you convinced? Let us know your thoughts.