Should emerging market investors buy commodities?

Abstract

One reason that investors hold commodities is to receive diversification benefits. However, while an extensive set of existing studies demonstrate diversification benefits when investors hold international stocks or bonds, they are generally silent on the implications of holding commodities. Using an asset pricing framework, we investigate the benefits to investors from holding commodities, both individually and in portfolios. Generally, commodity and stock markets are integrated, although there are time-varying benefits to investors that are subject to sample period selection and investment horizon. We show that Asian investors receive positive risk adjusted returns in gold and rice markets but not in any of the other commodity markets investigated. The risk adjusted returns are time-varying: during the Asian financial crisis risk adjusted returns were negative – a penalty for investing in commodities – whereas during the global financial crisis the reverse was true and investors earned positive excess returns. The time-varying nature of the benefits that arise from diversification in commodities and their breakdown during periods of crisis, highlight the problems that investors may face when using commodities for long-term investment in addition to traditional holdings of stocks and bonds.

Keywords:

• commodities
• financial market integration
• international asset pricing
• systematic risk
• market risk

JEL Classification:

• F15
• F2
• F36
• G10
• G15

Notes

¹ For example, see Gérard et al. (2003), Chi et al. (2006), Jeon et al. (2006), Christoffersen et al. (2012) and Hammoudeh et al. (2014). Sarafrazi et al. (2014) discussed diversification benefits from holding oil, gold and silver for investors in some developed markets.

² The World Gold Council (2013) shows that demand for gold jewellery in Asia was worth US$6 billion in the fourth quarter of 2012, behind China and India with US$14.6 billion. Total gold demand including investment and technology uses was US$66.2 billion in the fourth quarter 2012.

³ The Shanghai Metal Exchange Market does not trade iron or steel. Since the 27th March 2009 steel (as rebar and wire rod) has traded as a future’s contract on the Shanghai Futures Exchange (SHFE). The contract size for both products is 10 deliverable tonnes, is listed for 6 consecutive months and is the third most active contract after rubber and copper. http://www.shfe.com.cn/

⁴ We refer to the definition of Asia described in IMF (2012).

⁵ ASEAN includes the original ASEAN-5 nations of Indonesia, Malaysia, the Philippines, Singapore and Thailand and the recent members of Brunei, Burma (Myanmar), Cambodia, Laos, and Vietnam. The IMF refers to ‘Developing Asia’ as comprising the Islamic Republic of Afghanistan, Bangladesh, Bhutan, Brunei Darussalam, Cambodia, Republic of Fiji, Kiribati, Lao People’s Democratic Republic, Maldives, Myanmar, Nepal, Pakistan, Papua New Guinea, Samoa, Solomon Islands, Sri Lanka, Timor-Leste, Tonga, Tuvalu, and Vanuatu. Brunei, Cambodia, Laos and Myanmar are also members of ASEAN.

⁶ See Chi et al. (2006), Jeon et al. (2006), Arouri and Foulquier (2012), Arouri et al. (2012) among many others. As noted by Gérard et al. (2003), the price of market risk is the expected compensation that an investor would receive for taking on a unit of world covariance risk. However, given the likely situation of partial segmentation, then expected returns are a function of both global market risk and nondiversifiable local market risk.