| Commodities much less volatile than perceived |
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| 18/02/2007 | |
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In the last five years, investors have committed $75bn to commodities and thanks to a surge in energy prices, the sector continues to benefit from strong inflows. At the start of this year, the Goldman Sachs Commodity Index – a good measure of money flows into the sector – was increased from $70bn to $110bn. Yet if you dig further into the seemingly loamy soil which constitutes commodities, you may find that the Goldman index in particular and the sanguine headlines in general, belie a more fundamental truth: commodity assets as a broad group hardly offer uniform returns, and when one considers the basket of all commodities futures contracts on a historic basis, underperformance to equities is more the norm than the exception. Contrary to popular wisdom, this much-misunderstood asset class is also less volatile than normally perceived with low correlation between commodity assets, offering investors a powerful tool for diversification. "The problem with the Goldman Sachs Commodity Index is that it is 75% energy," says Harry Kat, Professor of Risk Management at Cass Business School London. Ever the contrarian, Dr. Kat points out that with the exception of oil, commodities have been on a never-ending downtrend since the 1950s. "The spikes last two to three years," he says, "and that's not good news is it?" Avoid orange juice, not just in the morning Indeed, the average futures returns (with the exception of energy) have been closer to zero based on the returns of 142 futures contracts from 1965 to 2005. The lowest is oats (-9.90%), followed by corn (-8.78%), orange juice (-7.56%), coffee (-5.97%), gold (-4.74%), live cattle (5.10%), copper (8.6%), heating oil (16.10%), unleaded (21.40%). "The futures do not offer a consistent risk premium and there is no correlation between them," says Kats. When considering volatility, commodity futures have been in line with that of large cap US stocks. Unleaded has exhibited a volatility of 35.8%, coffee (35.7%), heating oil (33.8%), oats (29%), orange juice (27.6%), copper (25.5%), gold (19.3%), live cattle (16.8%). These results can be compared to the Dow Jones Industrial Average Component, which posted an average volatility of 29.5% from 1965 to 2005. "People claim commodities are so much more volatile than equity, but in reality they are comparable to stocks." Another measure of volatility is skewness which measures the probability of an extremely high or low return. In order for skewness to be significant it has to be above one. Kats points out that there is little skewness in commodities futures returns. Skewness is probably one of the most difficult parameters in statistics as one extreme observation could make a big difference in the results. When considering oil, for example, prices dropped 40% in January 1991. That one event has contributed to a strong negative number for oil when calculating skewness, which is why investors may want to give less weight when calculating skewness for oil. Given these findings, an investor may ask why invest in commodities futures? The short-hand answer is diversification. The correlation between commodities in different groupings is very low even within the group known as softs (cocoa, sugar, orange juice, coffee, cotton), though those within energy is high. And commodity futures are particularly un-correlated with stocks and bonds. They are, however, positively correlated to unexpected inflation. Sugar futures returns have a particularly close correlation (.45) to the Consumer Price Index as do copper (.54) and heating oil (.39), whereas coffee and cotton much less. Looking at the business cycle, Kats concludes: "You want to have oats and cocoa at the end of a recession, but avoid heating oil." VB |
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