Wide diversification is only required when investors do not understand what they are doing – Warren Buffett
The above quote is a key support for my view that investing in index-wide vehicles is merely an exercise in di-worse-ification. It’s time to get specific. Commodities have often been lauded as a “key diversifier” but within the last 18 to 24 months, the case has broken down. Investors using commodity ETFs to enhance the risk-adjusted return of their portfolios may be falling foul of Buffett’s quote. Here I provide a warning to those who may be taking on more risk in their portfolios than they realise…
When constructing a portfolio, diversification is a key focus. Capital is allocated across asset classes in an attempt to produce an attractive risk / return profile. The search is made for investments which post returns completely uncorrelated to other investments, thus helping reduce the volatility of the portfolio since at times when one market may be experiencing a pull-back, another may be exhibiting strong returns entirely unaffected by the input moving the first market.
Historically the commodity markets have been used as such an asset class. An essential ingredient to a well-diversified portfolio, especially one heavily invested in equities. The commodity markets were used mainly by commodity producing companies to lock-in the price for their output (by taking the other side of the trade using options) and enable management to budget adequately.
However, recently this relationship appears to have been contaminated. In speaking to George Zivic (Managing Partner of Almanac Capital) to get a better insight, he maintained that this is a structural change. The increase of investors speculating in the commodity markets has led to a higher percentage of the traders treating the instruments inline with any other risk asset.
As you can see from the above the movements in the price of the US equity index and that of the commodity index have exhibited a heightened level of correlation.
Furthermore, as you can see from the below chart, the differential between the winning and losing commodity returns has been a great trade for an investor wishing to minimise net exposure to a highly volatile market
It is no longer the time to gain exposure via passive investing / ETFs etc. The smart money will be making smarter investments – DIFFERENTIATE between commodities, with their different supply / demand characteristics – again, EXPLOIT CONTAGION when some will be over-punished or over-pushed. With the majority of an “all-commodity” ETF invested in the energy markets, at least for the short term alpha generation will focus on the markets with far less visibility, less research focus and less investor attention. “Niche”-type investments in weather derivatives, agriculture etc. offer less correlated returns and greater diversification benefits.