2nd March 2011
Just how have market dynamics changed to cause so many to take on more risk than they realize, and are there any investment opportunities remaining in the commodity space to get round the issue?
When constructing a portfolio, diversification is often a key focus for risk management.
Capital is allocated across asset classes in an attempt to produce an attractive risk / return profile.
At times when one market may be experiencing a pullback, another may be performing strongly, helping to smooth out returns and reducing volatility. Crucially this requires the performance of different asset classes to be driven by different factors.
From producer dominated…
Exposure to the commodity markets has long been used as an essential ingredient in building a diversified portfolio.
The commodity markets were historically used mainly by commodity producing companies to lock-in the price for their output and enable management to budget adequately.
This meant that the majority of traders buying and selling commodities were focused on factors distinct from the issues driving investors to trade stocks.
… to speculator driven
However, recent market moves have shown the correlation between commodities and equities to be at near all time highs. So what's changed? The answer can be found in the investor base.
Over the last couple of years we have seen a significant increase of "speculators" trading the commodity markets.
Now many traders of oil, for example, are not looking to hedge out the risk of moves in the price of their products but instead are treating the instruments inline with any other risk asset.
As investors become more bullish, they invest more into the equity markets and buy oil. When they turned cautious, they take risk off the table across the board, leading to magnified losses for those invested in both oil and equities.
But agriculture avoids the angst
With commodity indices substantially exposed to the energy markets, investors can be misled into thinking that commodities, across the board, no longer provide diversification benefits for those with significant equity exposure.
However, the dynamics are not always the same! Agriculture, in contrast to oil, continues to be far more correlated to weather patterns than a "risk-on risk-off" strategy.
Regardless of also having a large percentage (around 80%) of their investor base consisting of "speculators", the factors driving trading patterns are different.
So what can we conclude?
Therefore, no matter the environment, or the market conditions, there are opportunities within the commodity space to benefit balanced portfolios.
As we move forward, a focus on portfolio construction and the investments that could help minimize correlations seems a smart move to help us achieve our return targets on a risk-adjusted basis.
Gemma Godfrey is head of research and chairman of the investment committee at Credo Capital, a former hedge fund manager at GAM and a quantum physicist by background. Follow her on twitter @GCGodfrey