Swedroe: Financializing Commodities

The traditional economic view is that, as is the case with most other commodities, crude oil is considered a real asset, with prices determined by the physical supply and demand. Because the vast majority of long and short positions in crude oil futures are closed prior to maturity, trading in futures doesn’t affect the price of physical crude oil.

However, this view has been challenged due to the increased presence of financial investors in commodity markets, a phenomenon that has been called “financialization.” Indeed, inflows into commodity market futures grew from $15 billion in 2004 to more than $250 billion by 2009.

Financializing Crude Oil

Zeno Adams and Maria Kartsakli contribute to the literature with their July 2017 study, “Has Crude Oil Become a Financial Asset? Evidence from Ten Years of Financialization.” To answer the question posed in the title of their paper, they use regression analysis of fundamental economic variables that have been the traditional drivers of commodities, as well as more recent variables that have been associated with financialization.

The four economic variables they analyzed are: economic activity (positively related to oil prices); real interest rates (negatively related to oil prices); changes in the level of inventories (consumers respond to fears of possible supply disruptions and stock-outs by increasing physical inventory levels, thereby increasing oil’s price); and the U.S. dollar’s exchange rate (because oil is priced in U.S. dollars, a rise in its value increases the local currency price of oil, negatively impacting demand).

The four financialization variables they analyzed are: the VIX index (negatively related to oil prices); stock prices (positively related to oil prices); macroeconomic uncertainty (which is negatively related to oil prices and computed by taking the average over more than 130 economic indicators such as industrial production, employment and hours worked); and the commodity risk premium (the futures yield curve, which reflects the demand imbalance for commodity futures positions, with backwardation/contango reflecting a positive/negative risk premium).

Increased Influence Of Financial Variables

The authors found that each of the eight variables they studied had low correlations with the others, justifying their inclusion in the model. Following is a summary of their findings:

• Since the beginning of the financialization period (September 2008, marked by the Lehman Brothers failure), financial variables explain 35% of the variation in crude oil returns versus just 11% in the prior period.
• Financial variables currently can explain 53% of the variation in crude oil volatility, up from 19% in the period prior to the failure of Lehman Brothers. Economic fundamental variables currently can explain just 21% of the variation in crude oil volatility.

These findings led Adams and Kartsakli to conclude: “Our empirical findings suggest that financial variables are not only responsible for explaining crude oil behavior but also for the transmission of risk to crude oil markets.”

They go on to add: “Financialization partly transformed crude oil from a physical to a financial asset in terms of pricing behavior. This can have important implications for the hedging effectiveness of commercial traders and the diversification benefits of commodity investors.”

They continue: “The size and persistence of our results suggest that the financialization of commodity markets may be more than a temporary phenomenon. If financial investors are the cause of the financialization process the change in nature towards a financial asset is likely to continue until other assets attract investor attention causing a redirection of investment flows.”

Damaging Trend?

The preceding findings are supported by those of Adam Zaremba, author of the study “Is Financialization Killing Commodity Investments?”, which appeared in the Summer 2015 issue of the Journal of Alternative Investments.

Zaremba investigated, from the perspective of a U.S. investor, financialization’s impact on the roll returns on futures contracts.

He focused on two issues: whether the financialization of commodities has impacted the roll return and, if it had a negative impact, whether that fact calls into question the efficiency of including an allocation to commodities in a portfolio, either as a portfolio enhancer or as a stand-alone investment.

Two-Stage Study

He divided his study into two stages. The first was to investigate whether financialization had impacted roll returns. The second was to investigate any impact a change in roll returns may have had on issues related to portfolio efficiency. Zaremba’s study covered the period 1990 through 2012, and used the JPMorgan Commodity Curve Index (JPMCCI) as a proxy for the return on commodities as an asset class.

Zaremba’s analysis of the data led him to estimate—and he emphasized that it should only be treated as an estimate—that financialization had led to an expected roll return about 0.38% per month (about 4.5% per year) lower than the average for the full period.

This, in turn, led him to conclude that, while incorporating commodities in a portfolio pre-financialization may have been efficient, the decrease in the roll return calls that conclusion into question.

He writes: “As a result of the process of the commodity market’s financialization, the benefits of commodity investments in terms of portfolio may not be valid anymore.” He added, however, that “they still may turn attractive if roll yields enter their positive territory anew.”

Diversification Benefits Reduced

The evidence suggests that financialization has led to changes that are, as Adams and Kartsakli state, “sufficiently large to transform the very nature of crude oil, away from a physical real asset towards a variable that shows a behavior that is comparable to stocks, bonds, and other financial assets.” Thus, the diversification benefits—which justify investors’ inclusion of commodities in a diversified portfolio—have been reduced.

Finally, an interesting alternative fund to consider, though only about 15% of its assets are invested in commodities (in long-short strategies), is the relatively new AQR Style Premia Alternative Fund (QSPRX). It was launched at the end of October 2013.

The fund seeks to provide long-term positive forward-looking return expectations with low correlation to traditional asset classes through investing long and short in a broad spectrum of asset classes and markets.

It uses market-neutral, long/short strategies across six asset groups and four distinct investment styles. The asset groups are the stocks of major developed markets, country indices, bond futures, interest rate futures, currencies and commodities.

The investment styles are value, momentum (which should not be confused with trend-following, as momentum is a relative measure, while trend is an absolute measure), carry and defensive.

Commodities are invested across the momentum, carry and value styles. In 2014, 2015 and 2016, the fund returned 11.3%, 8.8% and -0.4%, respectively. It has returned 5.9% this year through Sept. 19.

Conclusion

It’s important to note that, while this fund has higher forward-looking return expectations (with less volatility) than an investment in commodities, and provides some other diversification benefits, it wouldn’t provide the hedge against unexpected inflation that a fully collateralized allocation to commodity futures would.

(In the interest of full disclosure, I have a significant investment in the fund, and my firm, Buckingham Strategic Wealth, recommends it and other AQR funds in constructing client portfolios.)

Larry Swedroe is the director of research for The BAM Alliance, a community of more than 140 independent registered investment advisors throughout the country.