Rouwenhorst: Correlation In Commodities Up
Geert Rouwenhorst is probably best known as one of the first to hail the virtues of commodities as a bona fide asset class helping fuel the proliferation of commodities indexes and the ETFs that have followed them in the past decade or so. The Yale School of Management professor and deputy director for the International Financial Center at the university is also a partner at SummerHaven Investment Management, and the mastermind behind some of the benchmarks underlying United States Commodity Funds' ETFs, including the United States Commodity Index Fund (USCI).
In anticipation of his keynote speech at IndexUniverse's upcoming Inside Commodities conference in Chicago, he caught up with IndexUniverse Correspondent Cinthia Murphy, and acknowledged the challenges of creating a catch-all broad commodities benchmark. But he was also quick to say that despite rising correlation between various commodities due to the increasing acceptance of commodities as an asset class, they remain strong diversification tools that should be found in every investor's portfolio.
Murphy:Your work has been key to the rise of commodities ETFs. They have in fact been one of the fastest-growing ETF asset classes recently. But some argue that there’s no such thing as commodities beta. How do you define commodities beta?
Rouwenhorst :Beta is a measure of the sensitivity of an investment to broad market movements. In equity markets, which is where the notion of a beta was first used, “the market” usually means a broadly diversified portfolio that includes many stocks, usually weighted by market capitalization. The average stock beta is 1. Stocks with a beta above 1 would on average move more than 1-for-1 with the market, whereas stocks with betas below 1 would have less sensitivity to market movements.
A similar calculation can, in principle, be performed for commodities markets. How sensitive are individual commodities to the overall commodity market? In commodity markets, there is less agreement on what the appropriate broad market benchmark is.
Murphy:What are some of the challenges with creating a catch-all commodities index that would be viewed as a broad benchmark akin to the way the S'P 500 is viewed for equities?
Rouwenhorst :First, most commodity indexes are constructed from futures prices, and therefore exclude commodities for which there is an important spot market, but no futures market. Next, there is no natural weighting scheme equivalent to market capitalization in commodity futures, because for every long there is a short in futures:The overall net market cap of any futures contract is zero. This is why commodity indexes have looked elsewhere to determine weights. The earliest indexes used a combination of world production and liquidity and other factors to determine the index weights.
Murphy:So, how does one capture true commodities beta?
Rouwenhorst: Of course, betas cannot be observed in practice, and have to be estimated. In this estimation, I would choose an index that is well-diversified to calculate betas. Or alternatively, always be clear and report the index that is used to calculate beta. If a majority of investors use a particular index as their benchmark, then that could be an alternative as well.
Sometimes people take commodities beta to mean the sensitivity of commodities (as an asset class) to the overall stock market. This would be more like the “equity beta” of commodities. Beta defined this way has historically been low, and during some periods even negative. In recent years, the correlation between commodities and equities has increased, and the equity beta of commodities has turned positive. Some researchers have attributed this to the “financialization” of commodities.
Murphy:How much correlation is there between commodities?
Rouwenhorst: They are net positively correlated to each other. We’ve seen typical commodities correlation of about 10 percent in the past 40-year history, but in the last three years, that correlation has jumped to 50 percent.
Murphy:Why such a steep jump?
Rouwenhorst: Some people say that’s happening partly due to the fact that investors are thinking more and more of commodities as an asset class. But also because investors are trading in and out of these commodities simultaneously in a way they didn’t before. On the surface, you might think corn and natural gas have little to do with each other unless you are barbecuing, but they are more correlated today than they were in the past because of that phenomenon.
Murphy:Is that increase in correlation a positive thing for investors at the end of the day?
Rouwenhorst: If commodities become more correlated to each other, it becomes more difficult to construct a diversified portfolio of commodities. So, on net, that’s a negative for investors. But on the other hand, because of that same interest in commodities, the number of liquid commodities markets is growing, offering investors more diversification venues. It’s similar to what happened in emerging markets. When emerging markets became available to investors, their correlation to each other began to creep up, making diversification more difficult, but investors were also compensated with more venues in which to diversify. Any single market provides less diversification in itself, but the increase in their number means there are more markets to diversify across. This is a net positive.
Murphy:What do you see as the next generation of commodities indexes? Is there a way to play the futures curves that is not possible with an ETF today?
Rouwenhorst: Innovation will continue in the commodities area, I’m sure. We are seeing a movement towards actively managed ETFs in general, a trend that will likely continue going forward. In those strategies, an underlying manager can use discretion to create a portfolio. There is, of course, no guarantee that a manager can beat a well-designed index.
Murphy:You helped develop the index strategy behind USCI through SummerHaven. What makes USCI a better choice over the cheaper DBC, or even a dividend-paying GUNR that doesn’t have to deal with contango?
Rouwenhorst :USCI has a unique philosophy and approach among all commodity ETFs. It is dynamic, and allocates to different commodities each month based on the fundamentals of scarcity. The goal is to avoid high-inventory commodities that are typically in contango, and focus on the low-inventory half of the commodity space. Research has shown that this has historically led to incremental returns for investors.
ETFs that invest in commodity producers are a way to access commodities at an earlier stage of the production cycle. It is not a bet on pure price risk of commodities, but additionally embeds firm-specific risk. Remember the oil spill in the Gulf of Mexico? An investment in oil giant BP turned out to be more than just a bet on the price of crude. Having said this, modern portfolio theory would suggest that investors hold some of all assets in their portfolios, unless these assets are perfectly correlated.
Murphy:Energy is a big player in the commodities space. A lot of the largest commodity indexes are heavily weighted toward energy. Should investors follow that kind of allocation in their own commodity portfolios?
Rouwenhorst :The high weighting of energy is a historical artifact. There’s really no natural way of weighting a commodity in an index. There’s no market capitalization measure on commodities futures—for every long there’s a short and that’s it. So, commodities indexes tend to look at world production and trading volume numbers, measures that put a lot of weight on oil. But that has nothing to do with prospective returns for investors.
Oil is attractive when there are low inventories, which brings me back to the rationale behind USCI:You should own oil when it’s in backwardation and get rid of it when it’s in steep contango. You don’t necessarily need discretionary management to do that; you can have a rule that controls that allocation.
Murphy:Let’s talk physical commodities ETFs. Do you think physical gold ETFs have taken capital away from gold miners?
Rouwenhorst: I’m not worried about the gold market at all. Gold is unique in the way that it’s almost more of a currency than it’s a commodity. Gold is used as storage of wealth around the world. These ETFs are small relative to the overall size of the market.
Murphy:From a storage perspective, are physical ETFs that focus on commodities other than precious metals viable? Why is there such a delay in bringing them to market?
Rouwenhorst: For most commodities, their value is not a mechanism to store wealth, but rather an input in the productive process. If you think about a physically backed aluminum ETF, for instance, you would be requiring the ETF provider to buy and store aluminum to back up shares of the fund in a way that would take aluminum off the market. It would create a competing investment demand for aluminum in addition to its traditional industrial demand, not to mention that it would be very difficult to store $1 billion worth of aluminum—it’d be much harder than storing gold. Gold is currently worth more than $20,000 per pound, while one pound of aluminum trades for less than $1 on the LME.
This concern over competing demand could be what’s happening with physical copper ETFs. You could always just go long on copper futures contracts, but buying a physical ETF would require the fund to buy and hold copper that would otherwise be used by the industry. I think that might have stalled plans for these funds that are sitting in the regulatory pipeline.
Murphy:What’s your outlook for commodities in the near term and longer term?
Rouwenhorst: All commodity markets are different, and are affected by different factors, both on the demand and supply side of the market. Demand for industrial metals and energy are of course influenced by the world business cycle. Weather has of course been the big story this summer, and it will be interesting to see whether there are indeed trends in long-term climate patterns that some people have argued will become increasingly important. Commodities are interesting, because a crisis on the supply side of the market often leads to gains for investors. Commodity prices spike when there is a drought, a strike or a threat to political stability that threatens to interrupt supplies.
In addition to the business cycle, there is another common factor that affects many commodities simultaneously, and that is inflation. Inflation is currently still low, but the enormous liquidity creation of the past few years around the world may eventually translate into higher prices of commodities.
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