Latest Commodities Indicator: Fed Policy
By Jacob Bunge
As with any asset class, commodities investing often can come down to getting into and out of a given market at the right time. Sounds simple, until you factor in fundamental factors, time horizons, the waxing and waning strength of the U.S. dollar and what the OPEC secretary general had for breakfast this morning.
Wouldn't it be nice if there were some sort of signal - a flashing neon sign telling investors when to ratchet up their commodities allocation, and when to scale it back?
Dr. Gerald R. Jensen, professor of finance at Northern Illinois University in DeKalb, Ill., believes there may be such a neon sign. It's in Washington and currently headed by Ben Bernanke. It's the U.S. Federal Reserve.
"If you think about Fed policy, frequently one of the major inputs is inflationary concerns, and if you think about investing in commodities, they often serve as an inflation hedge," Dr. Jensen said. "When there's considerable uncertainty around inflation, that's when [the Fed] tends to initiate a restrictive policy stance, and those periods of time are when the stock market tends to do poorly."
During those same restrictive policy periods - when the Federal Reserve is in the process of raising interest rates - a broad-based allocation to commodities tends to do well, according to Dr. Jensen.
Dr. Jensen's research focuses on the relationship between monetary conditions and security returns, and he's been studying the portfolio effects of commodities investing since 2000. The new findings are part of a working paper titled "Commodity Futures and Style Investing," which Dr. Jensen has developed with Dr. C. Mitchell Conover of Virginia's University of Richmond and Dr. Jeffrey Mercer of Texas Tech University in Lubbock, Texas.
Range of Monetary Periods Covered
Dr. Jensen and his colleagues examined a 37-year time frame ending in September 2007, which covered a range of monetary periods. The sample began in December 1970, when the Fed initiated an expansive monetary period and began lowering rates; it ran through September 2007, when the Fed ended a four-year period of restrictive monetary policy, ending a period of rising interest rates in response to the unfolding credit crisis. The 37-year sample was split more or less evenly between expansive and restrictive Federal Reserve policy periods, according to Dr. Jensen.
Over the sample period, the researchers evaluated mean monthly returns of five equity strategies - value, growth, trend/momentum, small-cap and large-cap - as well as the mean monthly return of each strategy with a 5%, 10% and 15% allocation to the S&P GSCI.
Dr. Jensen and his colleagues found that a constant allocation to commodities shaved a few basis points off returns when the Fed lowered interest rates, and added to returns during periods of rising interest rates. In all instances, however, adding commodities exposure to an equities strategy meant a lower standard deviation. "There's always a risk reduction benefit," said Dr. Jensen, who noted that exposure to commodity futures needed to be greater than 5% of a portfolio to achieve a noticeable reduction in risk.
"During expansive monetary periods, you're paying for that risk reduction by giving up a significant amount of return, and during restrictive monetary periods, you're able to increase returns significantly and reduce risk considerably," he said. "So you get the best of both worlds during restrictive conditions."
Using a small cap-focused equity index as an example, Dr. Jensen and his colleagues determined that over the 37-year sample period, an initial investment of $5 would have grown to $94, with a standard deviation of 6.19%. That same portfolio, with a constant 15% allocation to commodities, would have grown to $105, with a standard deviation of 5.34%.
But with a tactical allocation to commodities - investing 15% in the S&P GSCI during periods of restrictive Fed monetary policy, and shifting that investment back into the small-cap strategy during expansive periods - that same $5 investment would have grown to $154, according to Dr. Jensen, though the risk benefit would depend on whether the correlation was somewhat consistent across the periods. Other equities strategies showed a similar performance gain, he said, although it was somewhat less pronounced in the trend/momentum-focused portfolio.
Other studies have examined the relationship between tactical commodities exposure and macroeconomic factors. In 1996, Steve Strongin and Melanie Petsch found a relationship between S&P GSCI performance and rising inflation, while Theo Nijman and Laurentius Swinkels in 2003 studied tactical allocation to the S&P GSCI in response to variables such as bond yields and the rate of inflation. More recently, Ana-Maria Fuertes, Joëlle Miffre and Georgios Rallis last year looked at the combined role of momentum and term structure signals as part of a tactical allocation to commodities markets. However, Mr. Jensen said that the research he and his colleagues have done with regard to the Federal Reserve policy's influence on varying commodities-equities portfolios is unique.
The research, which Dr. Jensen said he and his colleagues plan to publish soon, may lead to further studies. Dr. Jensen said that the trio might develop an alternative commodities index based on monetary conditions, with sectors weighted according to the risk/return benefits of the asset class.
Specific Modeling Approach
"The benefits of commodity futures may be understated because [existing commodities indexes] are not designed to measure investment benefits," said Dr. Jensen. "Those indexes include all the commodities, whether they make sense in an investment portfolio or not, because their weighting scheme isn't designed to capture that. We would use monetary conditions as an input into the modeling approach."
It also remains to be seen whether the risk/return benefits of a tactical allocation to commodities based on Federal Reserve monetary policy will continue in the future. Since the Fed initiated a period of lower rates in August 2007, equity markets have generally plunged, while many commodities have charted new highs. Though commodities markets have seen a pullback in recent weeks, the S&P GSCI remained up 16.9% for the year through late August, while the S&P 500 was down 13.4% and the Dow Jones Industrial Average was down approximately 14%.
One possible explanation for this apparent reversal, Dr. Jensen said, is that the Fed's monetary policy may now have less influence than it has had in the past. The creation in recent years of so many securitized products allowed financial institutions to move assets off their books and free up additional funds, he said, and the Federal Reserve's most recent period of rate tightening may not have had the anticipated effect. Likewise, he added, the Fed's effort to expand liquidity in the past year has been hampered by the continuing danger presented by these securitized products, which many institutions are reluctant to hold.
"So it may take a little time before the financial markets figure these things out and start operating in a more normal fashion," said Dr. Jensen. "We won't know for some time."
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