The Many C’s of Commodities and Defining Their Diversification - Hedge Fund Alpha (formerly ValueWalk Premium)

The Many C’s of Commodities and Defining Their Diversification

There is something to alliteration with the letter C. In education circles, the Four C’s describe different skills necessary in the 21st century: Communication, Collaboration, Critical Thinking , and Creativity. The world of Diamonds[1] also has four C’s: Color, Cut, Clarity, and Carat. Five if you include Cost.

Q2 2022 hedge fund letters, conferences and more

herbert2512 / Pixabay

In the world of Commodities, we also have an odd propensity to the letter C. Not counting industry words like Chicago, CTA, CME, and Corey Hoffstein, there are at least eight markets following the path of alliteration.

Admittedly, this is meaningless. But what we do find interesting about Commodity markets is their dissimilarity. Commodities are often lumped into one group but contain unique return drivers. We’ve written about this before, looking at Corn and Cattle. In fact, we believe you’ll find more diversification with commodities compared to a similar size basket of stocks.

To put this idea to the test, here’s an alliterative look at the correlations within baskets of commodities and stocks within the last year. Naturally, they all start with C.

 

[1] Little known fact – at one point you could trade Diamond futures on the Indian Commodity Exchange. https://www.business-standard.com/article/markets/icex-launches-the-world-s-first-diamond-futures-contract-117082800788_1.html

Correlations were measured based on daily price change from 7/27/21 – 7/28/22.

So, what are the implications of this?

Despite popular indexes like the S&P GSCI and RICI providing blunt information about “commodities,” the markets comprising those indexes aren’t monolithic. Sometimes it’s crucial to the Cubs’ AVG or OBP, but that’s a very blunt statistic. Knowing the idiosyncratic value that the next player (commodity) brings is more critical when assembling your team.

Switching sports analogies, this is precisely why Dennis Rodman was so valuable to the 90’s Bulls. For a more quantitative exploration into that question, check out Chris Cole’s white paper that uses Dennis Rodman as a metaphor for Long Vol strategies.

In contrast, adding the next stock to your portfolio may not add as much diversification as you think. To be fair, there are many more stocks than commodities. However, especially with the increase in passive investing, a systemic “tide”  can affect virtually all equities.

Furthermore, if you’re thinking about adding “commodities” to your portfolio(a goal we heartily agree with), your method and vehicle matter. A passive index is one way, but funds with actively traded strategies are better suited to capture each commodity’s unique risk sources. Companies want to grow and be more

profitable, increasing stock prices. The bias is always to the long side in equities. Corn and Crude Oil don’t care about your holdings like Caterpillar does, and Carbon Emissions surely doesn’t. These markets are more subject to supply-side factors pushing prices up and down. So consider Trend Following strategies are better suited to profit from those price moves. The data confirms this.

What next? Here are three actions you can do right now; take a look through a Managed Futures database for ideas, talk to a broker about opportunities that fit your situation, and listen to one of our many playlists that cover topics like why adding an investment may not always add value.. You never know, it may in fact concentrate your risk even more!

Article by RCM-Alternatives.


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