The Impossible Quest for Diversification


Are commodities still diversifying in today’s integrated financial markets? By Steve Ohana & Jean-Jacques Ohana


COMMODITIES MARKETS HAVE long been considered as relatively isolated from the turbulence of financial markets due to their close connection to supply and demand cycles. It has often been argued that commodities bring diversification


to portfolios of financial assets thanks to their lack of correlation to the stock market and their positive correlation to inflation. In fact, financialized post-Lehman commodity markets have little to do with the commodity markets of the 1980s and 1990s, where futures markets were dominated by hedgers and commodities prices were evolving according to inventory cycles. From consumables deriving their value from their use as inputs in industrial processes, commodities have become an integrated investment class1


subject, like other financial


assets, to the versatility of investors’ attitude towards risk. In this context, the evolution of commodities prices can only be understood by taking a broader perspective on the speculative mechanisms underlying financial markets in the era of financialization.


.. commodities have become an integrated investment class subject ... to the versatility of investors’ attitude towards risk


Financial markets have undergone profound


transformations over the past five years. In Figure 1, we observe that 2006 represents an important breaking point in the level of financial markets integration; the Lehman’s demise in September 2008 has further increased market interconnectedness in a structural rather than transitory manner as the effect is still present more than two years after. There was an increased density of the cross-asset correlation network after 2006. Risky assets average correlation network of the period 2002-2006 was 23%, rising to 43% between 2007-2010. Several factors have contributed to this dramatic


evolution. On the one hand, lax monetary policy has favoured the recourse to the wholesale funding market to finance investment strategies. On the other hand, the use of short-term performance measures (like Return-on- Equity or Sharpe Ratio) to benchmark banks and hedge funds strategies has aligned financial players’ positions. Both factors have aggravated players’ interconnectedness, and this in turn has strengthened asset class integration. The wholesale funding market and the forced asset


liquidations of distressed financial institutions serve indeed as canals of transmission of the shocks from one asset


This indicator corresponds to the proportion of the global daily asset price variations (i.e. the equities, corporate credit, currencies, bonds, interest rates


futures, and commodities’ price variations) which can be explained by a common risk factor, viewed as the average dynamics of risky assets against bonds.


class to another. An improvement in global financing conditions (e.g. caused by some important asset price rises improving bank balance sheets) allows fund managers to leverage further their positions in their other assets, boosting in turn their prices. Conversely, a deterioration of liquidity conditions (margin calls due to losses in a given asset class,


Figure 1: Financial & Commodities Integration


This indicator corresponds to the proportion of the global daily commodity price


variations (i.e. base / precious metals, agriculture, energy) which can be explained by a common risk factor, viewed as the average dynamics of commodity prices.


Source: Riskelia December 2010 9


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