We hear rather a lot about how price movements in commodities are driven by fears of inflation and investment decisions from pension funds and investors keen to hedge against inflation. I have always wondered how accurate this assumption is but have lacked the time (or intellect) to challenge the concept. Pension funds and others seeking long term returns have been diverting an increasing share of their funds into commodities this decade in the belief that commodities are an effective hedge against inflation. According to an FT article, much of this thinking is based on a ground breaking paper written in 2004 by Gary Gorton of the Wharton School at the University of Pennsylvania and Geert Rouwenhorst of the Yale School of Management.
They created an equally weighted commodity index to study how it would have behaved relative to inflation between 1959 and 2004. Their conclusion was that commodity futures are “positively correlated with inflation, unexpected inflation and changes in expected inflation. They went further, saying commodity futures surpassed other mainstream asset classes in the degree of correlation, displaying a correlation of 0.45 with inflation over five-year periods, compared to correlations of -0.22 for bonds and -0.25 for equities. As a result, significant levels of investment have been made in commodities over the last five years and much of the rise in oil and metals prior to the crash of 2008 was blamed by some on just such inflows of money.
However more recent research by Watson Wyatt a consultancy looking at data from 1970 to date suggests that if one drills a bit deeper one can see the only time when commodities correlate well with inflation is in times of high inflation and that this is only relevant for about 25% of the time. Their conclusion is commodities are less dependent on general inflation than they are on good old supply and demand.
In defense, many would say the proportion of pension funds and other investors monies diverted into commodities is small, however much inflation is sighted as a reason for inflows the reality is investors don’t bet heavily on commodities for this reason. In this FT article, Barclays Capital is quoted as estimating that total commodity assets under management stood at just $224bn at the end of the third quarter, up by 37% this year, compared to trillions in other asset classes. What about Exchange Traded Funds or more accurately Exchange Traded Commodities or ETC’s, why do we hear a lot about their impact? Could pension funds be using ETC’s as their inflation hedge? Assets under management in exchange traded commodity products, totaled just $105.9bn worldwide at the end of the third quarter, according to data from Barclays Global Investors, compared with $933.5bn in general exchange traded funds. A survey on alternative assets under management by pension funds also shows commodities are insignificant. Just 0.4% of the $872bn held in alternative assets for pension funds by the 100 largest alternative investment managers is in commodities.
The conclusions one can draw from these points are several. For one, the latest research suggests commodities do not make a good hedge against inflation except in times of high inflation which comparatively speaking is rare. Another is that maybe investors have already cottoned onto this and in fact contrary to what we hear, pension funds and the like hold only a very small percentage of their investments in commodities as a result. Third, inflows into ETC’s and other forms of commodity investment are much more to do with a belief in the super cycle theories peddled by Goldman Sachs and the like than they are about hedging against inflation. Commodities continue to hold a level of interest because of belief they are an undervalued asset class which is, at least for a while, worth attention. The extension of this could be that if commodity prices stagnate in a period of more balanced supply and demand then investors funds will focus more on equities and other opportunities if that resulted in lower volatility for metals I suspect it is a result most of us would welcome.