It’s nice to see the that the tide might be changing on views towards commodities. I’ve been saying for years now that commodities are not an asset class and that Wall Street created the myth that they are so they could push a new series of products on us all. Commodities are a cost input that rarely outperforms the pace of inflation over long timeframes. Anyhow, Izabella Kaminska points us towards a BIS paper that comes to the same conclusion about commodities, but rounds out the discussion:
“In the recent years several commentators hinted at an increase of the correlation between equity and commodity prices, and blamed investment in commodity-related products for this. First, this paper investigates such claims by looking at various measures of correlation. Next, we assess what are the implications of higher correlations between oil and equity prices for asset allocation. We develop a time-varying Bayesian Dynamic Conditional Correlation model for volatilities and correlations and find that joint modelling commodity and equity prices produces more accurate point and density forecasts, which lead to substantial benefits in portfolio allocation.This, however, comes at the price of higher portfolio volatility. Therefore, the popular view that commodities are to be included in one’s portfolio as a hedging device is not grounded.
This paper has shown that the correlation between commodity and equity returns has substantially increased after the onset of the recent financial crisis. We have then investigated the joint predictability of commodity and equity returns, and its benets in a dynamic asset allocation exercise. Relative to a benchmark random-walk model, a bivariate Bayesian DCC model, which can account for time variation in the correlation pattern, produces statistically more accurate density forecasts and gives large economic gains in an asset allocation exercise. The value of an active strategy based on DCC forecasts is large compared to passive strategies during turbulent times. At the same time, an investment strategy which also includes commodities in a portfolio produces substantially higher volatility and not always produces higher Sharpe ratios. This is at odds with the common notion that commodities serve as a hedge.
Private and institutional investors have displayed an increasing appetite for commodities over the past years. Our findings have far-fetching policy implications in this respect. On one side, our results provide empirical support for the inclusion of commodities in a portfolio. At the same time, however, we have also found that this comes at the cost of an increase in volatility. Therefore, the growing appetite for commodities is likely to produce more volatile portfolios.Digging further into the financial stability implications of the increasing correlation of commodity and equity returns is a relevant subject for future research.”
Mr. Roche is the Founder and Chief Investment Officer of Discipline Funds.Discipline Funds is a low fee financial advisory firm with a focus on helping people be more disciplined with their finances.
He is also the author of Pragmatic Capitalism: What Every Investor Needs to Understand About Money and Finance, Understanding the Modern Monetary System and Understanding Modern Portfolio Construction.