Commodities as a Diversification Instrument: Implications of the Commodity Financialization

Abstract: This study examines if potential diversification benefits from adding non- energy commodity indices to a portfolio consisting of stocks and bonds have changed over time. This is examined for two types of investors: one that aims to maximize the risk-adjusted return and one who seeks to minimize the portfolio risk. Due to the financialization of commodities, Tang and Xiong (2012) among others have argued that non-energy commodities have become increasingly correlated with equity. This study's findings on how diversification benefits have change over time is mixed. For the minimum variance investor diversification benefits have declined due to the financialization, while for the maximum Sharpe ratio investor diversification benefits have actually increased over time. These findings suggest that the financialization of commodity mar- kets might not be permanent, or at least it has not transformed non-energy commodity indices to an adverse diversification instrument.