Will Commodities Hold Up as Diversifiers?

Arijit Dutta: Hi, my name is Arijit Dutta; I'm a mutual fund analyst at Morningstar. I have with me today Mihir Worah, portfolio manager of PIMCO Commodity Real Return, which is by far the biggest mutual fund in the commodity futures space. And Mihir also runs PIMCO Real Return, which is the second biggest Treasury inflation protected bond, or TIPS fund.

Mihir, thank you so much for stopping by here today.

Mihir Worah: Thanks, it's a pleasure.

Dutta: I wanted to start with a big question on everybody's mind from the experience last year, [which] is that maybe the diversification argument in favor of commodities investment is not so strong based on what happened last year.

It seems like there's a belief now, that as more and more investors have piled into the commodities space, it's necessarily so that commodities as an asset class have gotten more correlated with other financial assets. How would you respond to that allegation?

Worah: That's a great question, and it's an important point. Because as you point out, several investors--besides the inflation hedging abilities of investment commodities--[use commodities] to diversify their investment portfolios from the regular financial assets, like bonds and equities.

And it's clear that what happened in 2008 during the crisis of the fourth quarter of 2008, every asset except U.S. Treasuries went down in price at the same time, as levered investors had to unwind their holdings in every asset--whether it was equities, it was corporate bonds, or it was commodities--all at the same time. And you saw prices going down together.

So in moments of de-levering crisis, it's well known that correlations between uncorrelated assets go to 1.0, which is what we saw in 2008. The question is, what are we likely to see going forward?

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Going forward, I don't think the argument that commodities are a diversifying asset has gone away. Commodities continue to react in price to different factors than equities and bonds do. And to choose extreme examples, you can think of the agricultural commodities--wheat, corn. They react to rainfall, the weather, what have planting expectations done, as opposed to what equities and bonds react to. Similarly for livestock.

Coming to the commodities that have, over some periods of time, correlations with the business cycle--the metals and energy--the question is, what will those commodities do? How correlated or uncorrelated are they to the business cycle and to equities? And at different times the correlations can go up or down depending on supply/demand situations on the ground.

Let me give you an example. Right now, commodity prices--energy, especially, crude oil, and to a large extent industrial metals, copper, aluminum--are reacting to perceptions of economic strength in Asia, China in particular.

So to that extent, they are fairly uncorrelated with the U.S. stock market, with equities in the U.S. People still get a diversification from U.S. equities [with commodities]. And what's happening in China is, because of the flood of liquidity into the Chinese system, right now the authorities, to get over the crisis, allowed that liquidity to flow pell-mell where it may--into the Chinese stock market, into the Chinese real economy.

And so the Chinese real economy has recovered, as has the Chinese stock market, as have commodity prices. But commodity prices are reacting to the Chinese real economy, demand out of Asia.

The authorities are trying to rein this back, and liquidity and stimulus in Asia is going to be more fine-tuned to make sure that it goes into the real economy and not into the stock market. To that extent, once again you see a divergence between what commodities do reacting to supply and demand in the real economy, and what financial assets do.

So I do think that even though you will go through short periods of time where correlations rise, over long horizons the diversification aspects of commodities should hold.