Commodity futures as an asset class: an empirical evidence from Indian market

Abstract

The risk-reduction benefit of diversification is an important aspect of financial management. However, the traditional choice of asset allocation for a risk averse investor in the portfolio includes stocks, bonds and treasury bills (T-bills). The research examines the role of commodity futures as an asset class in a traditional portfolio for a rational Indian investor, whose objective is to build a portfolio that maximizes the excess return per unit of total risk. Commodity futures are investigated as an alternative asset class since the factors that drive the commodity prices (e.g., weather and geopolitical conditions, supply constraints in the physical production, and event risk) are distinct from those that determine the value of stocks and bonds. The decision to include an alternative asset to a traditional portfolio for diversification depends not only on the temporal risk-return characteristics but also on how it correlates with the other assets in the portfolio over time. Therefore, to study and analyse the asset like properties of commodity futures the research is carried out in two phases. Firstly, it examines the long term statistical relationship of commodity future prices with other asset classes and also investigates the short term dynamics of prices by testing for the existence and direction of inter-temporal Granger-causality between the indices. The second phase tests the diversifying properties of commodity futures by examining the role of commodity futures as an asset class in a traditional portfolio consisting of equity and bond using mean variance optimization technique at various risk aversion levels of the investor. The analysis is based on the daily prices for the indices, Equity (S&P CNX Nifty), Bond (NSE G-Sec), Treasury Bill (NSE TB Index) and Commodity futures (MCX COMDEX) for the period June, 2005 to December, 2011. The findings show that commodity futures have a significant low correlation with equity and statistically significant negative relationship with bond. Moreover, there is no long term co-integration between the prices of commodity future and equity. Therefore, it can be inferred that an investor with long term investment horizon would benefit by including commodity futures to a traditional portfolio. Given that commodity futures have high returns and low risk when compared to equity and bond, it can also be considered as a standalone asset. On comparing the portfolios with and without commodities, the introduction of commodities provided an increase in the returns without a corresponding rise in risk. It also provides evidence that with the increase in risk aversion levels of the investor, allocation to commodity futures tends to increase. Thus, the investment in this asset class may facilitate the institutional investors, fund managers and retail investor to reap better returns during the inflationary periods when the equity prices are in bullish trend. The present study has enriched the understanding of commodity futures as an alternative asset for a rational Indian investor who uses only buy and hold strategy. This study provides insights for future researches on the role of commodity futures in diversifying investor’s portfolio to maximise the returns in conjunction with other investment tools and exploring various trading strategies