Issue: 36
Sent: 01-05-2006 21:15:20
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Commodity Prices: What Impact on Investing? - John A Robertson
A US-based study suggests that there is a role for commodities in a portfolio to help diversify the risk characteristics which are faced by an investor.
In a paper entitled "Facts And Fantasies About Commodity Futures", Gary Gorton (the Wharton School, University of Pennsylvania and the National Bureau of Economic Research) and K. Geert Rouwenhorst (Yale University) investigate the behaviour of commodity futures prices and stock and bond returns.
While their analysis is undertaken in a US investment context, it provides some pointers to the general behaviour of commodity prices in the context of an investment portfolio.
Gorton and Rouwenhorst constructed an index of commodity futures prices covering 37 individual commodities traded on the principal London and U.S. futures markets using data from July 1959 to December 2004. The commodity coverage extends well beyond the typical commodities which are important to Australia's minerals industry to include foodstuffs, metals, energy and animal product raw materials. The availability of a lengthy data set enabled the researchers to assess returns over a full range of likely economic conditions.
The tables at http://www.thebigpicture.com.au/atc/commodity_futures.htm summarize the results of the analysis for the index of commodity futures prices, stocks (represented by total returns from the S&P 500 index) and bonds (represented by the Ibbotson corporate bond total return index) over the same time frame.
Commodity futures returns are positively skewed while stock returns are skewed negatively (i.e. equities have more weight in the left tail of the return distribution while commodity futures have more weight in the right tail).
Commodities display relatively high kurtosis indicating more realizations in the tails than would be expected based on a normal distribution.
The average historical risk premium of commodity futures has been 5.2% a year, only slightly less than the risk premium for US stocks and more than double the risk premium for US bonds. However, the standard deviation of stock returns is higher so the Sharpe ratio for stocks is lower than for commodity futures.
The slightly higher variance and negative skewness of equities implies more downside risk for them relative to commodity futures.
Commodity futures earn above average returns when stocks earn below average returns.
Over all horizons except monthly (i.e. quarterly, yearly and five yearly), the commodity futures total return is negatively correlated with equities and long-term bonds. The negative correlation tends to increase with the holding period. There appear to be diversification benefits from holding commodity futures.
Commodity futures also appear to have diversification benefits across the business cycle. This is especially significant since business cycle risk is usually assumed to be a non diversifiable risk attaching to investment decisions. Commodity futures perform best as an investment in the late stages of an expansion. However, their best relative performance occurs in the early stage of recession when equity performance is at its worst and commodity futures displayed small positive returns. When commodity futures are falling in the late stages of recession, equity prices are likely to be strongest.
Futures v Stocks
In response to higher commodity prices, investors are often urged to buy the stocks of companies involved in producing those commodities.
The two authors seek to test the validity of this advice by matching companies and commodities using four-digit SIC codes. Over the 41 year period, the cumulative performance of commodity futures exceeded the cumulative performance of matching equities.
The authors found that the correlation between commodity company returns and the S&P 500 was higher than the correlation between commodity company returns and commodity futures. In other words, commodity company stocks behave more like other stocks than their commodity counterparts in the futures markets.
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