The inclusion of a commodity allocation in a portfolio is often considered as a diversifier and a good hedge on other more mainstream assets. But what happens when the traditionally uncorrelated commodity markets become increasingly correlated? And has this phenomenon changed in recent years? This article explores whether the more recent past has nevertheless proven that commodity investing still has a place as part of a global asset allocation, even more so in a long/short format.

Historically, the uncorrelated nature of commodity markets relative to other financial asset classes led to two things: the strong development of long commodity indices and, to a degree, the “financialisation” of the sector (meaning the process of alignment of commodities returns with pure financial assets). But in the immediate aftermath of the financial crisis, commodity markets exhibited less favourable correlation features and struggled relative to QE-supported equity markets.

A long-term perspective
Allocating to commodity markets makes sense in the long run from a pure portfolio construction point of view, because these markets have a low long-term historical correlation to other asset classes.

Over a long period passive commodity investment displayed low correlation to other financial assets such as currencies, equitiesand fixed income. Correlations between commodities are positive but low. The high correlation of energies and broad commodity indices over the long term is due to the relative importance of this sector over others in commodity indices.

While the correlation between equity and commodity markets increased during the financial crisis and the subsequent round of quantitative easing, this correlation has been declining since the middle of 2010 and more precisely since H2 2012 (see Fig.1). This reduction in correlation is even more remarkable when one compares the return of commodities to a portfolio made of equity and fixed income (see Fig.2).

The return of this uncorrelated feature is most welcome for commodity investors, but one hurdle remains: not all commodities are equivalent and fundamental supply and demand dynamics affect prices in a different fashion. For example, despite very strong months of July and August 2013, indices remain under pressure. The equally weighted commodity index (EWCI), which is the average of the S&P GSCI, Thomson Reuters/CRB and DJ UBS Commodity Index, was down 1.61% year to date as of August 2013. This is created by the dispersion in returns of the various types of commodities which make up the indices.

Less cross-sector correlation favours active investing
This reduction in the correlation of commodity markets to financial assets is due to a large extent to a decrease of cross-commodity correlation. This downward trend in cross sector correlation is put into evidence by looking at S&P GSCI sectors i.e., energies, precious metals, industrial metals, agriculturals and softs (as illustrated in Fig.3). As commodity sectors stopped moving in unison, correlation between sectors decreased to pre-2006 levels. Commodity market investors can take advantage of this performance differentiation by choosing to use actively managed strategies over passive investment approaches.

Opportunities for long/short investments
Although this downward trend of cross-correlation started a year and half ago, the year-to-date performance of some individual commodities illustrates even more startlingly some of these differences. As illustrated in Fig.4, a majority of the markets were down on the year and some markets were actually sharply down. Avoiding declining markets might not be enough to capture the full extent of commodity market moves. In such an environment, the ability to sell short creates value from a risk management perspective as a volatility dampener and from a profit-making perspective. Ultimately, long/short investing in commodities is a better fit for a more diverse environment. As mentioned above, market price weaknesses create opportunities for long/short investing in commodities. A fundamentally driven approach is more likely to result in proper harvesting of these opportunities in markets subject to short-term reversals. In 2013, it translated into a quite steady outperformance of commodity hedge fund indices over the EWCI, as illustrated in Fig.5. In addition, the outperformance of commodity hedge funds was achieved with significantly less volatility than in the underlying market while still capturing upward moves when they occurred. Hedge funds thus appear to be a well suited investment vehicle to access exposure to commodity markets while maintaining a significant level of protection on the downside.

Conclusions
The lessons for the opportunity set:

• Investing in commodity markets offers long-term diversification benefit. Cross-sector correlation is now back to pre-crisis levels, making the sector attractive again as a diversification tool.
• All commodities are not equal; thus, an active selection approach could benefit from return dispersion.
• It is possible to take even more advantage of this dispersion by using fundamentally driven long/short strategies.