Why are commodities over-represented in indices?

Do investors have an outdate view of commodities? Far from helping to diversify portfolios, or representing a tangible way to benefit from economic growth, commodities have become volatile financial plays. A misguided view of the nature of these assets has resulted in them being over-represented in indices. Indeed, many passive investors may be surprised to find how much commodities matter for their portfolios.

With the recent collapse in the shares of many mining companies, investment reports for the third quarter may not be happy reading for many. Far from offering protection against weak stockmarkets, metals and mining businesses now seem at the core of stockmarket problems. How should investors view this sector?

The appeal of physical commodities is in their seeming permanence and core role. Copper, iron and other metals have been used for millennia, with steadily rising use. Expected growth in China and emerging economies seemed to promise even greater demand. And, for many years the commodities cycle did behave differently than stockmarkets. This was the basis for some of the portfolio diversification claims. Commodities were promoted as an element of stability for long term planning by investors; an asset class that deserved a place in portfolios. How different is today’s reality.

As with most good things, extremes set in. Advocates for commodities grew firm in their belief in a commodities super-cycle that would last for decades. Investment banks and other financial vehicles entered commodity trading and production, with borrowing becoming a bigger part of mining finance. This boosted production of key metals, such as copper. Mega-mergers between mining giants, and huge new projects, became commonplace. The result has been a sector that now behaves more like the banking sector.

The mining sector created wealth not just by extracting and refining, but by trading, stockpiling and even lending metals to secure bank loans. As mining moved from its roots, its fortune became more closely intertwined with banking. Recent stockmarket behaviour points to the close links between the sectors.

Many investors might be uninterested in this, were it not for the disproportionate representation of mining businesses in the London stockmarket. This feeds in to indices and index funds, such as Exchange Traded Funds, that are based on these averages. And, given how closely many conventional actively-managed funds follow indices, the impact on most institutional and private portfolios has been significant.

This use of indices to guide risk assessment is encouraged by regulation, but in this case has not helped investors. Twelve months ago, the most broadly based index of UK shares, the FTSE All-Share Index, had 15% in oil and oil-related businesses, with 11% in mining. That weighting distorted perceptions of risk, and bore little relation to wealth creation in the British economy. Investors need a real-world understanding of risk, rather than simply relying on indices.

Added to the challenge of mining and energy, has been weakness in many “soft commodities” such as foods. Prices of coffee, orange juice and sugar in world markets have collapsed. All this builds a picture of deflation globally, rather than the inflation that central bankers seem to fear. Rising interest rates seem a long time away, despite the continued warnings of the Governor of the Bank of England.

It is the emerging economies that typically are the losers from this, with many nations having little except commodities to export. While the US Dollar itself has strengthened, making Dollar prices for goods worth more in local currency, it threatens a crisis in the developing world. It is not just miners that have borrowed at little cost in recent years, but many businesses in emerging economies have been helped by previously-cheap Dollars. That boost has ended, and re-payment of this debt could now prove difficult.

Turmoil in the commodity sector will trigger problems in many banks and emerging economies. Deflationary pressures are likely to persist, delaying a rise in US or UK interest rates. Instead, Europe and China are likely to stimulate further. It is clear that not even the mining giants or their bankers, are good forecasters of commodity or energy prices. Nor is it something that investors should attempt. Instead, investors should consider how their portfolios are positioned for this deflationary world, and reflect on whether commodities balance risk or increase it.

A version of this article was published in Personal Finance in The Herald on October 10 2015.

Disclosure: The opinions expressed in this article are my own, and may not represent the views of any firm or entity with which I am affiliated. The information presented in this article has been obtained from sources believed to be reliable, however, I make no representation as to their accuracy or completeness and accepts no liability for loss arising from the use of the material. Articles and information do not represent investment advice. I am a manager of actively invested equity funds.

Image credit: Lars Lentz ; licensed under the Creative Commons Attribution-Share Alike 1.0 Generic license. Some rights reserved.

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