ETF Trends
ETF Trends

It’s a little late for an Easter post but this saying is about one of the key investment principles, diversification.  Simply put, diversification happens when assets inside your portfolio move in opposite directions. The investment measure of diversification is correlation and it can range from -1.0 to +1.0. If correlation is -1.0 between two assets, then they have moved exactly opposite each other; conversely, if the correlation is +1.0, then they move exactly together.  Correlation of -1.0 is the holy grail of diversification to produce a more efficient portfolio – meaning for the same return, there is less risk, or for the same risk, there is higher return.

Commodities, which by definition of being the natural resources that are used to build society, are meaningfully different than financial assets like stocks and bonds. While they have been around since the beginning of time, most investors did not consider them a portfolio asset until about 10 years ago. They grew wildly popular with the institutional crowd as the major benchmark passed its 10-year track record, and with the advancement of ETFs, became popular (at least gold and oil) with retail investors.  At least for the institutions, the main reason for the attractiveness of the asset class was diversification.

Unfortunately for many, the diversification investors hoped for from their allocations to commodities fell flat as the correlation between commodities and commodities to other asset classes rose to almost 0.8 post the financial crisis.

There are two main reasons this happened:

1. The inventories were built up starting in the late 90′s to very high levels by 2005. Then the financial crisis hit, demand dropped and supply shocks (like the weather, war or pipeline bursts) lost their impact. This source of return from supply shocks or surprises, called expectational variance, that drives return patterns of commodities to be different from each other (gas to corn to gold) and to be different than other asset classes like stocks and bonds disappeared in the sea of excess inventory after the crisis.

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