"But commodities still need to be better understood. Some popular hedges do not work as well as managers hope. One is to use shares in commodity producers as a hedge against the underlying commodity. But Gorton and Rouwenhorst found that in the long run the correlation of commodity companies to commodity futures prices is 0.4, while their correlation to the S&P 500 is much higher at 0.57. Not much of a hedge, then."
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THE SHORT VIEW
Published: September 20 2006 03:00 | Last updated: September 20 2006 03:00
The letter that the Amaranth hedge fund sent to its investors this week served as a message to the whole market. It said its funds had "experienced significant losses in their energy-related investments following a dramatic move in natural gas prices" and that it was "aggressively reducing our natural gas exposure".
This raises questions about Amaranth. But it also provides a reminder of the risks in commodities trading, which has found its way into the investing mainstream, although appearing to be inadequately understood. This year saw the launch of several exchange-traded funds allowing the individual investor to play commodities, and a range of academic work suggesting commodities should now be part of institutional managers' asset allocation.
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A paper by finance professors Gary Gorton (of the University of Pennsylvania) and Geert Rouwenhorst (of Yale) has been particularly influential. Its critical finding was that commodity futures had historically offered the same return as equities, at the same level of risk, but that commodity returns were not correlated with stock returns.
This is a very persuasive case and there is a difference between using commodities as part of a broad mix and making the buccaneering bet that appears to have caused problems for Amaranth. But commodities still need to be better understood. Some popular hedges do not work as well as managers hope. One is to use shares in commodity producers as a hedge against the underlying commodity. But Gorton and Rouwenhorst found that in the long run the correlation of commodity companies to commodity futures prices is 0.4, while their correlation to the S&P 500 is much higher at 0.57. Not much of a hedge, then.
There are also questions over how commodities should be benchmarked. The Dow Jones-AIG Commodities index, and the Goldman Sachs Commodity index, the most widely followed, tell different stories. The former, weighted by quantities produced, is up 0.1 per cent over the last year; the latter, weighted by value and with more exposure to energy, is down 15 per cent.
Copyright The Financial Times Limited 2006
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