Mathew Kaleel warns that what might look like effective portfolio diversification might in fact be the opposite, if the correlations between asset classes are not clearly understood.
In the first article we submitted to Professional Planner we touched upon a number of themes we believe are important for investment portfolios.
One theme was ‘food’ and we argued that real assets such as commodities should be an effective additional to a traditional portfolio. We are often asked a question along the lines of “I hold BHP and Woodside shares, doesn’t this provide me with exposure to commodities?” Is this the case?
BHP – a barometer of commodity prices?
BHP Billiton is undoubtedly one of the great Australian success stories, a wonderful stock that has provided above average returns for many years, and due to its large weighting in the index has been widely held for many years.
Whilst we do not advise on stocks to hold, if we were only allowed to hold one resource stock, we would be hard pressed not to pick BHP due to its global diversification, quality management and free cash flows. This however does not answer the question above, ie does BHP provide effective commodities exposure?
The table below shows that over 38 years, BHP has a 0.72 correlation to the All Ordinaries Accumulation Index, ie 72 per cent of BHP’s returns are related to movements in the Australian stock market, whilst only 17 per cent of the returns are related to movements in the Goldman Sachs Commodities Index, an index of 24 commodities markets.
Therefore, we can answer the following questions with a good degree of confidence:
1. Is BHP a great Australian stock? Yes
2. Does BHP provides the potential diversification benefits of commodities? Not really
There are a number of reasons why this is so. Firstly, as a listed stock BHP is subject to the whims of capital flows in and out of markets. When there is a period of general optimism, BHP will tend to be swept along with other large ASX index components. Similarly, in periods of stock market dislocation, regardless of what commodity prices are doing, BHP will be sold off along with banks, larger retailers and insurance groups.
Secondly, and potentially more importantly, BHP is exposed to certain commodities more than others, being iron ore, coal, oil and other base metals. These are all important commodities no doubt, but there are other commodities that are (currently) not part of BHPs portfolio. These are also the commodities likely to provide a large part of the diversification benefits to a traditional portfolio.
So what commodities are we referring to? When we talk about commodities that offer significant potential diversification benefits going forward, we are referring to markets such as food, fibres (cotton), and precious metals, which tend to be more defensive and driven by different factors. It is our fundamental and long term view that the diversification benefits of commodities lies in good part to markets such as these.
Let’s start by looking at the question we raised above ie why BHP is so correlated to movements in stock markets. One reason is that over time, the resources which BHP has the greatest exposure to – base metals (copper, iron ore, aluminium etc) and energy markets (crude oil) have themselves become more correlated to movements in stocks. The chart below shows the correlation between the base metals and energy indices relative to the S&P500 over various time horizons.
Whilst over thirty years the correlation is quite low, the movement of these sectors has become more similar to the movements of broad stocks in the last one, two and five years.
Additionally, these sectors have become more correlated to each other, highlighting the growing dominance of the BRIC countries, especially China and India in altering the nature of commodity demand. As these economies consume greater quantities of the commodities required to industrialise (copper, oil, iron ore etc), they generate significant profits, taxes and royalties for the companies and countries that host these deposits (and thus underpin the general resilience of the commodity nations such as Australia and Canada).