This flows onto other sectors in the Australian economy, and equates to the higher correlation of these commodities and BHP to the broad Australian market. This does not however provide the diversification benefits that investors expect from commodities.
The second chart highlights the sectors which we touched upon above, ie the agricultural and precious metals markets. What we can see from this is something quite different.
Firstly, over almost all time frames, agricultural and precious metals markets have a relatively low, or negative correlation to the S&P, which is what an investor should be looking for in terms of a potential portfolio diversifier.
Secondly, the correlation between agricultural and precious metals markets over the last 30 years, and in the last twelve months has been low and negative. So again, having an exposure to both of these sectors does not concentrate risk but each may provide diversification in their own right.
Thirdly, there are not too many large cap Australian stocks that provide exposure to precious metals, and the one large cap stock that does – Newcrest Mining – has provided significantly higher returns over ten years than BHP.
Finally, there are not any stocks in the ASX20 that provide direct exposure to the movement of prices in corn, wheat, soybeans and soybean meal. This is perhaps the most significant reason for the low diversification between commodity prices and stocks in general.
Ramifications
We can make a number of assertions based upon the above findings:
1. BHP is a world class stock but not a proxy for commodity price movements;
2. Energy and base metals markets are become more correlated to stocks in general, reducing the diversification benefits these sectors offer to a traditional portfolio;
3. Exposure to agricultural and precious metals markets are currently providing the diversification benefits expected of commodities; and
4. The ‘China and India effect’ are probably a large part of the cause for this change in correlations.
This article ighlights the fact that a statement about a particular stock or asset class is often not correct. BHP is a great mining company, but not a proxy for commodities prices.
Commodity indices as a whole tend to be uncorrelated to other asset classes over longer time frames, but certain sectors – agricultural and precious metals markets – are much more effective as portfolio diversifiers than commodities that are more reliant on emerging market growth.
Finally, markets are not static; these relationships will change ongoingly, and the active monitoring of these relationships is crucial to ensure that adding an asset class with the goal of achieving diversification does not, as Warren Buffet stated so succinctly, lead to diworsification.
Mathew Kaleel is a director of H3 Global Advisors – www.h3global.com.au
