Diversification benefits of commodities

Diversification benefits of commodities

Investment portfolios that include commodities deliver a six per cent average increase in risk-adjusted returns for investors. The finding comes from a study co-authored by a researcher at Queen Mary University of London (QMUL).

Thursday 28 September 2017

The research shows that certain commodity strategies make investors better off when included in portfolios that consist of stocks, bonds, and cash.
The study is published in the Journal of Empirical Finance and is co-authored by Professor George Skiadopoulos from the School of Economics and Finance at QMUL. In contrast to the previous research on this subject, this study does not pose restrictive assumptions about investors’ preferences and assets distribution.
Investments in commodities have increased over the last number of years. A number of commodity investment vehicles have been developed for institutional investors to accelerate this growth - most notably commodity indices. These indices represent a menu of strategies ranging from long-only passive (first generation commodity indices) to dynamic (second generation commodity indices) and long/short (third generation commodity indices) strategies.
Professor George Skiadopoulos said: "The main argument for including commodities in investors’ portfolios is that they offer diversification benefits. We explored whether an investor who holds stocks, bonds and cash in her portfolio should also include commodities. While previous studies found mixed results for investors, we found that the inclusion of commodities in investors’ portfolios does make the investor better off. This is the case where the investor accesses commodities via the second and third generation commodity indices.  However, in contrast to common belief, this evidence is not unanimous for the first generation commodity indices."

Performance measures

The researchers verified this finding by examining a number of performance evaluation measures which also take transactions costs into account.  The researchers used an approach called ’stochastic dominance efficiency approach’ to test their theory.
Professor Skiadopoulos said: "This is what separates our study from others which have sought an answer to the same question. Previous studies have investigated the question of diversification benefits by making a series of assumptions about investors’ preferences and characteristics of asset returns - our approach circumvents the need to make such strong assumptions and thus it allowed for a much more robust methodology.  Our results also highlight that investors should not follow long-only passive investments in commodities and instead the more recently developed commodity strategies should be preferred."
The study is called ’ Diversification benefits of commodities: A stochastic dominance efficiency approach ’ and is accepted for publication in the Journal of Empirical Finance.