Diversify with Commodity ETFs as Correlation to Equities Declines
April 24th, 2014 at 2:30pm by Tom Lydon
As investment banks cut ties with their commodities units, commodity prices are beginning to show a lower correlation to the equities market. Investors can benefit from the greater diversification qualities of the asset class through related exchange traded funds.
David Bicchetti and Nicolas Maystre, economic affairs officers at the United Nations Conference on Trade and Development in Geneva, pointed out that the correlation between U.S. equities and corn, cattle and wheat dipped to less than 0.05 in January from 0.3 in 2008, reports Isaac Arnsdorf for Bloomberg.
“Now, we’re getting back to where strict supply-demand gives us truer pricing and hopefully better ability to look ahead,” Richard Nelson, chief strategist at Allendale Inc. said in the article.
According to a London Business School study, the increase in large speculators amplified the “unusual” boom and bust in the commodities market. Suleyman Basak and Anna Pavlova argued that institutional investors helped push up higher prices, volatility and correlation with other financial markets.
Now, the UN economists found that commodities are beginning to move more independently of stocks as banks like Barclays Plc, Deutsche Bank, JPMorgan Chase & Co. and Morgan Stanley have been exiting or diminishing their stake in the commodity markets in light of more stringent regulations, rising capital requirements and a tapering commodities super cycle, Reuters reports.
Under the new Vocker Rule, banks are restricted from trading their own account and the regulatory reforms expanded oversight of commodities derivatives.
“As financial investors including banks and hedge funds have reduced their activity in commodities markets in the last two years, we’ve seen a marked drop in the correlation between the returns on the equity markets and the returns on oil and other commodities futures markets,” Bicchetti said in the Reuters article.
As the correlation dips between commodities and equities, commodity ETFs may do a better job of diversifying a traditional investment portfolio of equities and fixed-income assets, providing investors with an asset that zigs while stocks zag. [Alternative Asset ETFs Diversify Portfolios]
For instance, the PowerShares DB Commodity Index Tracking Fund (NYSEArca: DBC) gained 3.4%, iPath Dow Jones-UBS Commodity Index Total Return ETN (NYSEArca: DJP) rose 9.7% and iShares GSCI Commodity-Indexed Trust (NYSEArca: GSG) increased 3.8% year-to-date. Meanwhile, the S&P 500 is up 2.1% so far this year.
“From 1970 to 2004, commodities were negatively correlated with other asset classes like global equities and domestic bonds,” according to Morningstar analyst Abby Woodham. “The correlation between commodities and the S&P 500 rose significantly after the financial crisis in 2008 but appears to be declining again today.”
For more information on the commodities market, visit our commodity ETFs category.
Max Chen contributed to this article.
The opinions and forecasts expressed herein are solely those of Tom Lydon, and may not actually come to pass. Information on this site should not be used or construed as an offer to sell, a solicitation of an offer to buy, or a recommendation for any product.