|Changing Commodities, Changing Indices|
|August 13, 2012-|
Page 1 of 2
Geert Rouwenhorst is probably best known as one of the first people to hail the virtues of commodities as a bona fide asset class, helping fuel the expansion of index-based investing in raw materials over the last decade. In an interview with IndexUniverse Correspondent Cinthia Murphy, Rouwenhorst acknowledges the challenges of creating a catch-all broad commodities benchmark, while arguing that raw materials still merit a place in every investor's portfolio.
[This interview originally appeared on our sister website, IndexUniverse.com]
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, 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 capitalisation. The average stock beta is 1. Stocks with a beta above 1 move on average 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 involved in creating a broad commodities benchmark, such as the S&P 500, for example, in US equities?
Rouwenhorst: First, most commodity indices 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 capitalisation 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 indices have looked elsewhere to determine weights. The earliest indices 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 “financialisation” 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. That’s a net negative for investors. 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 correlations 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.