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WisdomTree Europe: Diversified and Enhanced Commodities Investing – How to lower volatility

In our series on “Diversified And Enhanced Commodities Investing” we will discuss the merits of investing in a broad, diversified basket of commodities and how – when combined with an optimised roll strategy, can improve the performance profile of commodities as a stand-alone asset class and of multi-asset portfolios where commodities are included.

 

Single commodities are subject to specific and sometimes unique factors which drive price trends to be distinct and for volatility to be elevated.

The probability of historic average positive and negative returns can help better conceptualise volatility and the dispersion of returns of different asset classes.

Mixing single commodities to form a broad diversified commodity exposure can significantly reduce volatility compared to single commodities and broad equities.

In this first instalment, we take a closer look at some of the most important drivers responsible for the volatility seen in single commodities and how to mitigate with commodities diversification.   

Cyclicality

The forces driving volatility of single commodities are typically unique. Consider copper for example: Cyclical turning points in the economic and business cycle can overwhelm investor sentiment and shift latent secular trends. During the commodities boom instigated by China’s investment spending splurge from 2001 to 2007, copper futures rose 260%, 10 times as fast as the S&P 500. Copper’s marked price reversal since 2010 and the sharp price swings since, shows just how significant expectations around China’s outlook on export and infrastructure spending drive the soft / hard landing rhetoric and how closely tied they are into industrial metals sentiment.

Seasonality

Another factor driving volatility is seasonality and abnormal weather conditions, particularly prevalent in energy and agricultural sectors. Several snaps of cold weather in the US that extended into the spring and tightened and disrupted energy supply conditions in recent years have distorted prices of US natural gas futures, instigating shifting futures curves. With this has come large price swings as was seen in 2012 and 2013 when March contracts rolled over into April contracts. Other adverse weather conditions such as the severe droughts that devastated farmland and crops in the US, Russia, Egypt in recent years, which led to temporary – but large shortages –  also contributed to isolated but volatile price moves in food staples such as corn and wheat without affecting energy, precious and industrial metals. Supply and demand shocks reverberate around futures curves shifting in contango and backwardation will amplify volatility.

Regulation and Technology

Regulatory freedom and technology are further examples for why, within certain commodity sectors, price trends appear insulated from global macro trends.  The relative ease with which new technologies to extract mineral fuels such as hydraulic fracturing in shale formations have been adopted and scaled-up in the US has reinforced the decoupling of US natural gas prices from not just crude oil prices but also European natural gas prices. For instance, using OECD’s benchmark of average natural gas prices for Europe’s fragmented energy markets, US natural gas has been trading at a more than 60% discount to European natural gas effectively since 2010.

“Financialisation”

Reinforcing the distinct price trends in single commodities has also been the “financialisation” of commodity markets, through the development of exchange traded products (ETPs). These vehicles have unlocked large pools of wealth from retail and institutional investors., As a result, price discovery underpinned by the fundamental supply and demand expectations of primarily commercial traders is increasingly being affected by investors of different types. Strategic asset allocators as well as day traders and speculators now more often than not reinforce if not overwhelm, or on occasion disrupt trends in commodity prices.

 25052016en

Source: ETFWorld.co.uk

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