The “proxy argument” suggests that emerging market equities provide benefits because of commodity exposure. The author rejects this argument; he finds no evidence that commodity prices significantly affect the equity returns of emerging markets. He concludes that investors should invest in commodities through futures to get the benefits of portfolio diversification.
In recent years, many investors have been advised to add the commodity asset class to their investment portfolios for diversification and inflation protection. Some advisers have suggested that adding emerging market equity can work as a proxy for investing in commodities. The author shows that this “proxy argument,” which predicts that rising commodity prices will have a positive impact on emerging market stock returns, does not work as an investment strategy. He recommends that investors invest directly in commodities through futures.
How Is This Research Useful to Practitioners?
Anyone who is responsible for asset allocation would find this research useful. The common wisdom is that investors can attain the benefits of investing in commodities by investing in emerging market equity. The author finds a limited connection between an economy’s reliance on commodity production and the correlation of that country’s equity market with the commodity market.
By examining trade data, the author finds that the assumption that emerging market countries are mainly exporters of commodities is false. Actual import/export patterns make it difficult to trace the impact of commodity price changes on the overall market. The author provides extensive evidence and concludes that market practitioners should not expect their equity market exposure to act as a substitute for commodity exposure.
How Did the Author Conduct This Research?
The author examines the relationships between emerging market equity returns and commodity returns and finds that investing in commodity-related equities does not result in a commodity-like return. For example, commodity-linked companies’ stock performance diverges widely from that of their associated commodities. In addition, investing in shares of the largest global oil companies would result in very different returns from those of WTI (West Texas Intermediate) crude oil. The author shows that all equities have a strong correlation with the overall equity markets and a weaker correlation with commodity prices. The equity returns also have many drivers other than commodity prices. Furthermore, commodity-related companies hedge the impact of volatile commodity prices.
The MSCI Emerging Markets Index has a much lower correlation with the consumer price index than with the Dow Jones-UBS Commodity Index for the 10-year (2003–2012) period and the 5-year (2008–2012) period. The clear implication is that emerging market equity exposure does not serve as a proxy for commodity exposure.
The author uses import/export data to show how the commodity prices affect the emerging market economies. The proxy argument naively labels all emerging market nations simply as exporters of raw materials. Because emerging markets have a diverse profile of commodity export/import patterns, it is difficult to generalize the impact of commodity prices on emerging markets. The author tracks three commonly referenced proxy country/commodity pairs: Chile and copper, South Africa and gold, and Russia and crude oil. All three pairs demonstrate positive correlation but not a high enough correlation to indicate that these countries’ equity markets would be good proxies for the associated commodities.
This research is very relevant to practitioners and investment industry participants. Emerging market equity exposure is sometimes believed to provide the benefits of commodity exposure. The author very effectively proves that emerging market equity exposure is not the same as commodity exposure. He shows that emerging market exposure does not provide the portfolio diversification and inflation-fighting qualities that some market participants have been led to believe it provides.