Slightly more than a decade ago, several studies were published raising the possibility that an allocation to commodities (in the shape of fully collateralized futures) could improve the efficiency of a portfolio due to the diversification benefit (the low to negative correlation of commodities to both stocks and nominal bonds) provided through including this asset class.
The publication of these papers was closely followed by a dramatic increase in the demand for commodity investments, and Wall Street responded by creating a host of new alternative investment vehicles. Between 2004 and 2008 alone, it’s estimated that at least $100 billion moved into commodity futures. This increase in investor demand has led to what’s been called the “financialization” of commodities markets. As is always the case, an increase in demand impacts prices and expected returns.
Since the financialization of commodity markets is a relatively new phenomenon, its effects are still being debated within academic communities, and we don’t have much data to analyze.
A related question, however, is this: Even if it were possible to quantify the changes that financialization has brought, are they temporary? Or have they, in fact, resulted in a permanent change to the structure of the commodity markets?
Adam Zaremba—author of the study “Is Financialization Killing Commodity Investments?”, which appears in the Summer 2015 issue of The Journal of Alternative Investments—investigated, from the perspective of a U.S. investor, the impact of financialization on the roll returns of futures contracts.
This is an important issue, as roll returns are one of the three key components of returns from commodity futures. Before digging into the study, let’s take a brief look at the different ways in which it’s possible to invest in commodities.
Investing In Commodities
Exposure to commodities can be obtained by:
- Direct investment in physical commodities. With the exception of precious metals (such as gold), investing in physical commodities is complicated. It can involve storage, transportation and insurance. Thus, it’s generally not a practical option for most individual investors.
- Investment in commodity-related stocks. Unfortunately, the evidence demonstrates that commodity-related stocks are more highly correlated with stocks in general than with commodities themselves. They also tend to produce lower-than-equity returns.
- Fully collateralized commodity futures. Not only have returns to fully collateralized commodity futures exhibited low to negative correlation with stocks and bonds, but (unlike with stocks) their returns were positively correlated with inflation and thus provide a hedge against that risk.
We will now undertake a closer look at the sources of returns to collateralized commodity futures.