January 2, 2017

Are Commodities Still a Good Portfolio Diversifier?

Overfitting the data is a serious problem when constructing financial models. One way to guard against this is to have lots of data. This can help you determine if your results are robust by seeing how they hold up over different time periods.

But this assumes the underlying market dynamics remain stable over time. That is not always the case. Gogi Gerwal gives a good example of how you may be misled by extrapolating past results to the future. In his blog post, “Should We Consider Gold?” Gogi showed that adding gold to the Global Equities Momentum (GEM) model increased its annual return from 18% to 21%.

Source: SharpeReturns.ca

Gogi then pointed out that from 1971 to 1981 gold’s price went up 18-fold when the U.S. let the price rise to market levels. If we remove this period of unnatural price appreciation from the back test, GEM without gold has a higher return and less volatility.

This is an example of aggregation bias. By combining events that are different into one set of data, your results may look good. But appearances can be deceiving. Different market forces at work on different parts of the data means you should consider the periods separately. As momentum investors, we become sensitive to changing market conditions.

Commodity futures are another area where people may be misled using aggregated data. Here is a  long-term perspective on commodity performance versus stocks and bonds:

The blue line represents a traditional 60/40 balanced stock and bond portfolio. The green line is the popular S&P Goldman Sachs Commodity Index (GSCI) of commodity futures contracts. S&P GSCI had strong but erratic performance until mid-2008 when it collapsed.

There has been a strong disconnect in commodity index performance before and after 2008. We should see if the more recent performance is a normal variation or if it signals a change in market dynamics. This is important to know because many institutional investors use commodities to diversify their investment holdings. The Chartered Financial Analyst (CFA) curriculum recommends a 10% commodities allocation to a typical stock and bond portfolio.

Commodities Diversification

The idea of diversifying stocks and bonds with commodities first began with Gorton and Rouwenhorst (2005) in their paper, "Facts and Fantasies about Commodity Futures." They showed that from 1959 through 2004, a collateralized basket of 36 commodity futures had equity-like returns of 11.2% per year, while being negatively correlated to stocks. This meant a combination of commodities and equities could have large diversification benefits. In a 2006 report called "Strategic Asset Allocation and Commodities" commissioned by PIMCO, Ibbotson Associates also issued a report showing that commodities could be a valuable addition to traditional stock and bond portfolios.

Growth of Commodities

Following these two studies, institutional interest in passive, long-only commodity exposure skyrocketed. Goldman Sachs, PIMCO, and others aggressively marketed commodity index products. Many pension funds entered the market. Long positions in commodity indices went from $6 billion in 1999 to $256 billion by mid-2008. Annualized growth among the S&P GSCI commodities averaged 31% during the 2004-2006 period. This rate was nearly triple that of 2001-2003. Market participation by non-commercial traders tripled from 15% in 1990 to 42% in 2012. [1]

Despite poor performance since 2008, demand for commodities has remained strong. Commodity investments more than doubled from roughly $170 billion in July 2007 to $410 billion in February 2013. According to Bhardwaj, Gorton, and Rouwenhorst (2014) in their paper, "Facts and Fantasies About Commodity Futures Ten Years Later" open interest of the average commodity contract has more than doubled since 2004. Endowments, pension funds, hedge funds, and the public have all joined the bandwagon by adding commodity index futures to their portfolios. Following good performance in the 1980s and 1990s, speculative demand for commodities has also grown in the managed futures industry. Barclays Hedge reported that the amount in managed futures went from $50.9 billion in 2007 to $325 billion in 2014.
Financialization of Commodities

Increased participation of fund managers, pension plans and other financial investors created what some call the financialization of commodities. Under financialization, commodities are influenced by the aggregate risk appetite for financial assets and the investment behavior of commodity index investors. These investors have less commodity specific knowledge and a different attitude than commercial interests.

Financial investors enter or exit trades based on their perception of the macroeconomic situation, rather than on market specific fundamental factors. Increases in the supply of price insurance by financial investors has lowered the price hedgers pay for protection.

Financial investors improve the sharing of commodity price risk. Financial investors also channel volatility from outside markets to the commodity markets.

Source: Zaremba (2015), "Is Financialization Killing Commodity Investments?"

Increased Correlations

Financialization has also had an impact on the correlation of commodities to other assets. In their paper, "Financialization, Crisis and Commodity Correlation Dynamics," Silvennoinen and Thorp (2009) report on the conditional volatility and correlation dynamics of commodity futures from May 1990 until July 2009. They found increasing integration between the commodity and financial markets. Hedge fund managers were timing their futures exposure for hedging purposes.

Financialization means that returns from both commodity futures and stocks decrease in volatile markets. During the 2008 financial crises, the correlation between stocks and commodities shot up to over 0.80. Increasing correlation during times of financial stress diminishes the diversification value of commodities. Cheung and Miu (2010) also show in their paper "Diversification Benefits of Commodity Futures," that commodities are not a good diversifier in bearish equity environments. Bhardwaj et al. say that correlations increase in periods of market turmoil. Commodities are often acquired for their hedge-type protection during bear markets in stocks. But we see here that this kind of protection may no longer exist.

Commodities now may also be more correlated in general with other assets. The table below from Bhardwaj et al. shows the one-year correlation of commodity futures with stocks went from -0.10 in July 1959 through Dec 2004. to 0.60 from Jan 2005 through Dec 2014.

In their paper "Correlation in Commodity Futures and Equity Markets Around the World: Long-Run Trend and Short-Run Fluctuation," Li, Zhang, and Du (2011) looked at dynamic conditional correlations (DCC) from 2000 through 2010 between 45 country equity markets and the S&P GSCI index.  DCC preserves trends without smoothing fluctuations. Using DCC, the authors concluded, “… we are able to decisively disapprove the assertion that, despite recent history, commodities still provide portfolio diversification. Whether from the long-run or short-run perspective, the diversification value of the commodity futures index has, in general, vanished.” Li et al. attribute this to an increase in the integration between commodity futures and equity markets, and an increasing number of investors holding both commodity futures and equities.

Commodities may now also be more correlated to each other and to commodity indices, as we see from the Bhardwaj et al. study:.

In an interesting paper called "The Strategic and Tactical Value of Commodity Futures," Erb and Harvey (2006) show that the average annualized excess return for individual commodity futures from 1945 through 2004 was near zero. Portfolio returns of more than 10% came from mean reversion profits through portfolio rebalancing. Since correlations were so low back then, the diversification premium was enormous.

Lower Profits

If Erb and Harvey are correct and intra-commodity correlations are higher now due to financialization, then we should see lower commodity portfolio returns.  We should also see higher volatility. This is because commodities are bought and sold at the same time by financial investors rather than fluctuating independently based on their individual fundamentals.

There may be another reason why commodity futures returns are lower now. To see why, we need to understand how the futures markets work. Alpha Architect had a good overview of that last week.

In brief, there are three components of commodity futures return. They are the return from holding Treasury bills as collateral, spot return from changes in commodity prices, and the yield associated with rolling over futures contracts.

Importance of Roll Yield

According to Campbell & Company (2014) in "Deconstructing Futures Returns: The Role of Roll Yield", the cumulative impact of roll yield can be significant. In some cases, it is similar in size to the entire gain or loss an investor experiences over the lifetime of a trade. Erb and Harvey (2006) reported that from December 1982 to May 2004, roll returns explained 91% of the expected long-run cross sectional variation of commodity futures excess return. According to Anson (1998) in "Spot Returns, Roll Yield, and Diversification with Commodity Futures," roll yield provided most of commodity investments’ total excess return between 1982 and 1997. The S&P GSCI average annual roll yield then was 6.1%, while the average spot return was -.08%.

What happened to roll yield since financialization of commodities began? In the chart below, the difference between the commodities return and the commodity futures return is the roll yield.
Bhardwaj et al. show that the much of the reduction in commodity futures return in recent years is due to a lower collateral returns. But excess futures returns (futures returns less U.S. Treasury bill returns), have declined from 5.23% annually in 1959 through 2004 to 3.67% in 2005 through 2014 on an equal weight  portfolio. This is a 30% reduction in roll yield (risk premium). What is also important is the 26% increase in standard deviation from 12.1% in the earlier period to 15.23% in yhe later one. Return, volatility, and correlation are all are used in determining optimal portfolios.
Here is an explanation for why the risk premium has diminished. Hedgers can be on either side of a commodity market. When raw material prices go up, consumers still need to heat their homes, drive to work, and feed their families. Builders still need to buy lumber. There are no good substitutes for these things. This means the price elasticity of demand is generally low for commodity end products. Commercial interests who need to buy commodities can often pass price increases on to consumers rather than hedge future supply costs in the futures markets.

But the situation is different for commodity producers, such as farmers, mining and energy producers. They need to accept whatever the market prices is once their products are produced. To avoid the risk of not being able to cover their production costs, producers will hedge their price risk. They do this by selling futures contracts ahead of production that guarantees them a known selling price. Hedgers are willing to pay a premium to lay off this price risk. They offer speculators who take the other sides of their trades a positive return. More speculative activity now means less risk premium and lower roll yields.

In "Systematic Risk, Hedging Pressure, and Risk Premiums in Futures Markets," Bessembinder (1992) found that from 1967 through 1989, the average return of 16 non-financial futures was influenced by the degree of net hedging. Commodities in which hedgers were net short had positive excess returns for speculators to capture. When long-only financial investors entered these markets in force, the risk premiums they received from hedgers had to be spread out among many more participants.

The reduction in risk premium also helps explain the declining performance of commodity trading advisors (CTAs) in recent years. There has been less hedger premium available to them as well. In their paper, "Fooling Some of the People All of the Time: The Inefficient Performance and Persistence of Commodity Trading Advisors," Bhardwaj, Gorton, and Rouwenhorst (2013) reported that CTA excess returns over U.S. Treasury bills averaged only 1.8% from 1994 through 2102. This is not statistically different from zero.

Optimal Portfolios

With the trend toward higher correlations, higher volatility, and lower risk premiums, we should look again to see if commodity futures can still add value to a stock and bond portfolio. Besdies Bhardwaj et al. (2014), there have been three other academic studies addressing this question over the past five years. They all use more data from outside the financialization period than from within it. So their results are not overly biased toward recent events.

The first study was "Should Investors Include Commodities in Their Portfolios After All? New Evidence," by Daskalaki and Skiadopolous (2011). They looked at the S&P GSCI and DJ-UBSCI (now Bloomberg Commodity Index) from 1989 through 2009. Only one-quarter of their 20- year sample period was post-financialization. The authors did a portfolio spanning analysis. This shows what happens to the efficient frontier of optimal portfolios when you add more assets. They found that when you take higher order moments of the portfolio return distribution into account, commodities were not beneficial. When using rolling returns to construct out-of-sample data, the authors discovered that commodities were not beneficial even to mean variance investors.

The second study was "On the Correlation between Commodity and Equity Returns: Implications for Portfolio Allocation," by Lombardi and Ravazzolo (2013) of the Bank for International Settlements. They applied time-varying DCC correlations to the S&P GSCI and the MSCI Global Equities indices from 1980 through 2012. Again, only one-quarter of the data was post-financialization. These authors found the inclusion of commodities boosted returns for horizons of 2 to 4 weeks but at a cost of substantially higher volatility. They concluded that the idea of including commodities in one’s portfolio as a hedging device is not grounded.

The final study was "Portfolio Diversification with Commodities in Times of Financialization,"
by Zaremba (2015). He used spanning tests on the JP Morgan Commodity Curve Index data combined with stocks and bonds from 1991 through 2012. His conclusion was also that including commodity futures in a traditional stock and bond portfolio was no longer reasonable.

Front Running

There are a few more things that commodity index investors should be aware of. The first is a study by Mou (2011) called "Limits to Arbitrage and Commodity Index Investment: Front-Running the Goldman Roll." Mou examined the costs to investors of front running. This occurs when hedge funds or others buy the next month futures contracts just ahead of their usual rollover dates. Front runners then unwind their positions after prices have been pushed higher by index managers who bought the new contracts. Mou estimated that front running the S&P GSCI from January 2000 to March 2010 cost S&P GSCI index investors 3.6% in annual return. The popular S&P GSCI and Bloomberg commodity indices both use fixed rollover dates. Front running takes a toll on the performance of both indices, as well as on any funds using those indices.

Index Versus Fund Performance

One should also consider the costs associated with being in commodity index funds. I calculated the difference between index and fund returns since the start of the two oldest commodity index exchange-traded funds. The iShares S&P GSCI Commodity Indexed Trust (GSG) underperformed its index by 87 basis points per year. The iPath Bloomberg Commodity Total Return ETN (DJP) underperformed its index by 106 basis points. The annual expense ratio of both funds is 75 basis points. This accounts for some, but not all, of the difference in performance between the funds and the indices. None of the above portfolio optimization studies take these significant costs into account.

Weight of Evidence

Despite public information about lower roll yields, changing correlations, front running costs, and index expenses, researchers like Levine, Ooi, and Richardson (2016) are still positive about using commodity index futures as a portfolio diversifier. Their paper, "Commodities for the Long Run," does not discuss financialization. Instead, it uses a large amount of data to point out that commodity returns are sensitive to business cycle changes and the rate of inflation.

Here is a chart from Bhardwaj et al. (2014) showing returns of an equal-weighted commodity futures portfolio decade by decade. Both before and after inflation, we see that the latest decade is the only one where futures returns are below spot returns. In fact, they are substantially below. Something different is going on now after financialization of the commodity markets.

Even more telling is the following table from the Levine et al. paper itself:

Inside the red box are Sharpe ratios of the last two 20-year periods for portfolios with 90% of their assets in a 60/40 blend of stocks and bonds and 10% in commodities. (Allocating 10% of investment capital to commodity futures became widespread after the Gorton and Rouwenhorst paper in 2005.)
Portfolio Sharpe ratios take correlations, volatilities, and returns into account. The Sharpe ratios here are all about the same for the past 40 years. Thus, there has been no advantage in adding commodities to a balanced stock and bond portfolio. If you take front-running and commodity index fund expenses into account, an allocation to commodities would be even less desirable than a portfolio without them.

Aggregation Bias

Levine et al. say that their data extending back to 1877 implies that commodity futures add value to a diversified portfolio. Even if that is true, the nature of the commodity markets has changed significantly since the mid-2000s due to financialization. This means that data before financialization may not have as much relevancy. The Levine et al. optimal allocation to stocks, bonds, and commodities based on data from 1877 may not be the best one to use.

The three portfolio studies above, as well as the Levine et al. results over the past 40 years, may be a more accurate view of what to expect in the future. All four show that including commodities in a stock and bond portfolio is no longer beneficial.

Next Up

The reason I am discussing aggregation bias with commodities is two-fold. First, there are still many advisors and investors using commodities as a diversifier. They may want to reconsider that decision in light of the contrary evidence now.
The second reason has to do with factor-based investing. Factors have been growing in popularity and are expected to grow even more over the next few years. Yet they have many of the same issues as commodities with regard to aggregation bias, market impact, declining risk premia, front running, and unaccounted costs. This post has been an introduction to these issues. My next post will look at them in more detail in the light of factor-based investing.

[1] The CFTC does not always categorize hedgers and speculators correctly into commercial and non-commercial interests in their Commitments of Traders (COT) reports. The percentage of non-commercials mentioned here and elsewhere should be used with caution.