One of the oft-cited reasons for investing in commodities is that they have historical returns comparable to stocks while having a low correlation to the stock market. The problem is that this statement is patently false [emphasis mine].
Yes, commodities used to have low correlations to stocks. But that was before the era of “financialization” and securitization. In their 2011 paper “Index Investment and Financialization of Commodities,” Princeton University Professor Wei Xiong and Renmin University of China Professor Ke Tang prove empirically what many of us in the profession have long suspected: Commodities and commodity stocks are becoming more highly correlated to each other and to other asset classes.
Furthermore, while the prices of individual commodities have always been volatile, commodity prices as a whole have also become far more volatile in recent years.
The question begs to be asked: Why?
Tang and Xiong place the blame on the slew of ETF and mutual fund products that offer stock investors passive, indexed access to commodities. Whereas the equity and commodities markets used to be populated by very different types of investors and traders, there is now almost total overlap. It’s hard to find a traded commodity that doesn’t have an ETF or ETN that tracks it; the commodities market has become the stock market, and volatility in the one spills over into the other. The end result is that virtually all commodities track the price of oil now, and oil in turn tracks the stock market.
When academics first suggested commodities as a portfolio diversifier, they failed to understand how a massive increase in investor interest in the sector would affect the relationships between stocks and commodities and between the various commodities themselves. Call it the "Heisenberg Uncertainty Principle of Finance," if you will.
For investors today, this means that one of the primary reasons for including commodities in a diversified investment portfolio — the low correlation to stocks — is now largely moot. Talented speculators can still make a bundle trading commodities, of course. But longer-term investors would be better served allocating their funds elsewhere.
Tuesday, July 19, 2011
Are Commodity Investments Still the 'Non-Correlated' Way to Go ?
Not so, says Charles Lewis Sizemore in his SEEKING ALPHA post,'The Myth of Commodities Investment', excerpted heaviily below.