Friday, August 2, 2013

Sorry, commodities are a poor diversification tool

Financial Times: An interesting paper has just landed on the BIS working paper site, in which the myth that commodities provide a solid diversification tool for investment portfolios has been beautifully debunked. The grounds for this are mostly due to too much correlation, and volatility. Here’s the abstract (our emphasis):

In the recent years several commentators hinted at an increase of the correlation between equity and commodity prices, and blamed investment in commodity-related products for this. First, this paper investigates such claims by looking at various measures of correlation. Next, we assess what are the implications of higher correlations between oil and equity prices for asset allocation. We develop a time-varying Bayesian Dynamic Conditional Correlation model for volatilities and correlations and find that joint modelling commodity and equity prices produces more accurate point and density forecasts, which lead to substantial bene fits in portfolio allocation. This, however, comes at the price of higher portfolio volatility. Therefore, the popular view that commodities are to be included in one’s portfolio as a hedging device is not grounded.

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