Investors became enamored with commodities as an asset class in 2005. Two Yale professors, Gary Gorton and Geert Rouwenhorst, published a study that year using an index they had created using equally-weighted commodity futures.
The two wondered about the reasons investors would place a portion of their assets in a commodity futures index and the study was designed to find the answer.
They found that, over a 65-year period from July 1959 to December 2004, commodity futures offered a return premium over equities with low correlation to both the equities and bond markets.
Commodities also threw off those returns during different parts of the business cycle since they moved on supply and demand factors instead of the present value of a future payoff.
So commodity futures were viewed as a perfect way to hedge portfolios against the equities and bond markets, particularly during inflationary periods when equities and bonds tend to underperform.
Then everything changed. Beginning in the same year the study was published, prices on components like food began to rise instead of fall as they had done in previous decades.
For example, prices on a tonne of wheat rose from $105 per tonne in January of 2000 to $167 in 2006. By the time the food riots circled the globe in 2008, the price of wheat had catapulted to $481 per tonne.
Commodity ETFs made it even easier for Mr. and Mrs. Investor to get in on the party. TV ads bombarded households, touting just how easy it was and saying little about potential risks.
Commodity trading was now in vogue with the mainstream.The added liquidity from growing investor interest financialized commodity price movements, causing them to respond more in sync with equities and bond prices.
So Gorton and Rouwenhorst published another study in 2012, digging deeper into the performance characteristics of commodity futures. They discovered the index performed differently based on the level of commodity inventories.
They found that, during low-inventory periods, the asset class delivered a higher risk premium because they had greater exposure to shocks in supply and demand. Conversely, high inventory periods provided a cushion for such shocks.
They noted that, during times when inventories were low, users of actual commodities would make commitments to future purchases based on predictions that inventories would rise. This enabled them to lock in a lower price for future purchases. Users also would pay higher prices in the near term to ensure they have the materials they need immediately.
These discoveries showed that commodity prices still had sensitivity to inventories (supply and demand). They also illustrated that correlations to the equities and bond markets could vary significantly over time.
The commodities markets have grown substantially since the 2005 study and should continue to grow as emerging markets countries begin to exploit their natural resources through economic development.
This could mean that commodities might be a sensible way for investors to gain exposure to emerging markets while taking advantage of increased demand and price volatility due to still limited supply.
Commodity futures may provide diversification for your clients’ portfolios but the key realization is that this may not always be true. As global markets continue to develop, characteristics of this popular asset class could change further.
As with any high risk asset, clients need you to educate them on the risks inherent in certain asset classes and also on the best way to use them to achieve their investment objectives.
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