Wednesday, July 21, 2010

How diversifying are commodities?

I would like to address the issues raised by my last post about buy-and-hold vs. dynamic asset allocation about the diversifying properties of other asset classes, specifically commodities.

Are commodities diversifying?
AllAboutAlpha recently wrote about the death of commodities as an asset class. One of the studies cited was from RS Investments, where they show commodity prices are increasingly correlated to equity returns.

AllAboutAlpha concluded that commodities remain a good source of diversification since they are highly correlated to inflation.

One giant risk trade
Izabella Kaminska at FT Alphaville addressed the commodity diversification issue slightly differently by observing that commodities are increasingly correlated to stock market returns because of the stampede of institutional funds going into the asset class. She went on to discuss the lengths that some dealers and institutions have gone to in order to minimize the loss of returns from rolling the contango.

The rising correlation to equities and correlation to inflation both point to the same thing. The commodity trade has become just a risk trade.

When I view commodity prices through the inflation-deflation macroeconomic lens in the Inflation-Deflation Timer model and put it on the risk-safety axis, commodities have become the risk, or inflation/reflation trade. The other end of the deflation, or safety axis is occupied by the US Treasury long bond. By the way, equities are correlated with commodity prices because they, too, represent the risk trade, or reflation trade, albeit in a less volatile fashion.

Are commodities a good diversification building block? I am afraid not. They are just an extension of the reflation or risk trade represented by equities.

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