11 Pages Posted: 27 Sep 2012
Date Written: September 20, 2012
Despite the recent spike in cross-asset class correlations, commodities remain an asset class set apart by distinct risk factors that may enhance the diversification of traditional portfolios. Their superior performance relative to equities and fixed income in times of rising inflation may also help mitigate the negative effects of inflation risk.
Commodities have historically delivered equity-like performance over the long-term, albeit with significant variations in recent decades. A closer look at the roles of spot and roll return in performance variation over time suggests that spot return is the dominant driver of commodity index return variation over short-term periods, but roll return becomes increasingly important over longer-term horizons. Furthermore, due to the heterogeneous nature of commodity markets, there is significant cross-sectional variation across commodity sectors, which illustrates the importance of sector exposures in driving the risk and return of commodity index investment.
The building blocks of constructing a commodity index can also have significant implications on both its risk and return characteristics and investment applications. For instance, when evaluating standard versus enhanced/dynamic roll indices, trade-offs exist between roll return, liquidity, and beta exposure, which indicate that they may have different potential applications.
Furthermore, commodity index investments should also be evaluated in the context of the overall intended asset allocation objectives, such as portfolio diversification and inflation protection potential.
Keywords: Commodity Investments, Commodities Asset Class, Commodity Indices, Commodity Indexing, Portfolio Diversification, Inflation Protection, Inflation Hedge, S&P GSCI, Enhanced Roll, Dynamic Roll
JEL Classification: G10, G11
Suggested Citation: Suggested Citation