Do Commodities Still Provide Portfolio Diversification?

Do commodities still provide adequate diversification with the equity market?  It is an interesting question, especially in today’s context.  Since the financial crisis began in 2008, we’ve seen many asset classes move largely in tandem.  In particular, commodities and equities have moved in near lock step for the past year and a half.  Both fell sharply in late ’08 and early ’09, only to rebound for much of the rest of ’09 and now stay largely flat since the start of the fourth quarter of 2009.

In 2006, Gary Gorton and K Geert Rouwenhorst published an influential paper on the correlation between commodities and equities.  They researched 45 years of performance and noticed that commodities performed well when equities returns underperformed.  They concluded that commodities were a great way to broaden portfolios and spread risk. The research found that commodity futures, with Treasury bills as collateral, offered the same return as equities over the period of 1959 to 2004.  The research also found that historical risk in the commodities market was “relatively” low compared to that of equities.

However, since 2008, correlation between the S&P 500 (SPY) and the  S&P GSCI (GSG) commodity index has risen to nearly 0.8.  This has thrown into question whether commodities provide adequate diversification.

Source: ETFDesk.com

However, highlighted in a recent article in the Financial Times, the authors of the study are sticking to their guns. Although the past two years have shown a higher correlation between commodities and equities, over the long term commodity returns match those of equities, but with a negative correlation.

“You can argue whatever you want about the last three years, two years, one year, six months,” says Prof Gorton, 58. “That’s not how we do research,” he says in an interview with the Financial Times.

Source: Financial Times

Interestingly, the research also found that commodities track “unexpected” inflation quite well.  As more investors and managers fret about future inflation and below normal equity returns, it might just pay to increase portfolio holdings towards commodities.  For those investors that want to take a diversified approach to commodity investing, opposed to outright speculating on prices Gold, Oil, etc,  consider broadly diversified ETNs such as:

DJP iPath Dow Jones-AIG Commodity Index Total Return ETN

Source: ETFDesk.com

DBC PowerShares DB Commodity Index Tracking Fund

Source: ETFDesk.com

GSG iShares S&P GSCI Commodity-Indexed Trust

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