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When will the Commodities Indices myths collapse?

Posted on 09. juin, 2010 by Jean Jacques Ohana in Weekly Focus | Commentaires fermés

Two Commodities Indices have been designed to play a role in enhancing and diversifying global diversified portfolio returns: the GSCI and the DJ UBS (ex DJ AIG).

Both arguments are contradicted by the new financial reality.

Myth 1: diversification

Commodities are not any more a diversifier as the new zero rate paradigm makes them more similar to other risky asset classes: equities, corporate credit, emerging credit, hedge funds… Indeed, in this context, all assets yielding a premium are closely related in to global liquidity cycles and their successions of manias and panics. The network of connections between commodities and risky asset classes is very dense as demonstrated by the figure below:

When S&P returns are within the 10% lowest quantile, the network is even denser, which means that diversification is the lowest when we most need it:

Nevertheless, gold proves to be a powerful diversifying alternative to zero rate cash during financial crises.

Myth 2: return enhancement

Commodities index investment consists in buying commodities futures and rolling them to the following maturity before the contracts expire so that there is no physical delivery. This process provides very different returns from holding commodities and storing it in a facility, the differential coming from the commodities curve being either upward sloping (i.e. in contango) or downward sloping (i.e. in backwardation). Commodities financialization has led to a rise in commodities prices, which in turn has stimulated production (the new discovered price being more often than not above the production cost). In turn, commodities have been more often well supplied than they used to be, hence a higher and more frequent contango than before.

As a matter of fact, the contango is now structural on agriculture and energy markets. It will remain contained in base metals, precious metals as storage capacity is not costly and virtually unlimited. This consistent contango proved to be very costly over time mostly on agriculture and energy as demonstrated by the following data:

In the long run, consistent positive returns may be achieved through an active exposure to commodities (Riskelia could help in this regard) but certainly not through passive rolled long futures positions, whether they are managed under the GSCI or the DJ UBS.

When the diversification and return enhancement myths collapse, investors will brutally withdraw money from commodity indices. It is likely to happen in a deleveraging mode (such as the one we are experiencing today) when investors realize that these badly designed commodities indices don’t diversify portfolio and lose even more than other assets due to the contango.

So far, index investors have not lost their appetite for commodities… But should oil and base metals enter into a bearish trend, the index flows may reverse sharply, as already experienced after August 2008:

And if they do reverse, commodities will lose an important price support as Commodities Index Traders (CIT) account for 30% to 50% of Open Interests on most exchange-traded commodities…

Tags: Base Metals, Commodities Futures, Commodities Prices, Contango, Diversified Portfolio, Energy Markets, Financial Crises, Financial Reality, Global Liquidity, Gsci, Hedge Funds, Manias, Myth 2, Panics, Physical Delivery, Precious Metals, Storage Capacity, Successions, Zero Rate