While emerging markets may move in sympathy with commodity prices, there is far more than just commodity exposure at play.


This article first appeared in the Spring 2016 issue of Understanding Investments.

There is a body of thought that considers investment in emerging market equities a manner of commodity exposure. For investors who are worried about their US equity concentration, commodities, by way of futures contracts, have been put forward as a way to diversify the equity risk in a portfolio. This thinking has even extended to commodity exchange traded funds (ETFs). This is because the price performance of the S&P 500 has little influence on commodity prices. On the other hand, emerging markets with economies dominated by commodity production would be influenced by the underlying movement of commodity prices. Thus, emerging markets = commodities.

At first glance, the relationship between commodities and emerging markets seems to hold true. Chart 1 compares the iShares Emerging Market ETF (EEM) with the PowerShares DB Commodity Index Tracking Fund (DBC) on a percent change basis from 2007 to today. These ETFs were chosen as comparisons because they are available to any investor. EEM is often the main vehicle for investors’ exposure to emerging markets. DBC was chosen as EEM’s ETF equivalent in the commodity world. It tracks an index of futures contracts in energy, agriculture, industrial metals and precious metals. The pure commodity play, however, would be to invest directly in a commodity futures contract.

At first glance, EEM and DBC seem to move together. But is owning an emerging market ETF the same as investing in a commodity futures contract? Does the proxy theory make sense?

Trading View DBC/EEM

Further analysis shows that it does not. A basic statistical test shows that while EEM and DBC have a (slight) positive correlation of 0.51, there is a statistically significant difference between the price changes in EEM and DBC.

[1] That is, not all of the variation in the emerging markets ETF can be explained by variation in the broad based commodities ETF. This test hints at a complex relationship that deserves greater exploration.

In 2014, Timothy Atwill [2] conducted an in depth analysis of this question, building on his earlier work that showed commodity producers are not even proxies for commodities themselves. This is because 1) individual equity prices correlate the most with the overall equity market; 2) equity prices, as ownership claims, are influenced by factors that have no bearing on commodity prices; and 3) producers are aware of their exposure to spot prices and hedge that risk through futures and forward contracts. So equity prices that seem like they should move directly with commodity prices often don’t.

Atwill makes the same argument for the emerging markets thesis. Part of the proxy argument rests on the idea that the price correlation between emerging markets equities and commodity futures is higher than emerging markets and other equity markets. However, emerging markets and the US are more highly correlated. As with the relationship between commodities and commodity producers, at the end of the day, equities, even in disparate markets, are more likely to move together than with a different asset class.

We can also look at trade data to get a picture of the underlying fundamentals. A hypothetical country that increases their production and export of say, aluminum, should show a corresponding increase in sensitivity to aluminum prices in the country’s equity market. Instead, what export/import data shows is that all of the major countries in the emerging market index (China, Brazil, India) have diversified away from commodity production.

The commodity production scene is complicated. Top exporters are not necessarily emerging markets and top importers are not necessarily developed markets.  The US is the largest exporter of wheat and cotton. Nigeria and China are the top importers, respectively.

What does this mean? The risk/return profiles are not the same. Investors who look to commodities to diversify their US equity exposure should not take the emerging market proxy theory at face value. The benefit of investing in commodities via futures contracts is that prices are less linked to movements in the equity markets. To try to get that benefit by investing in another equity market, even one that seems more “exposed” to commodities, does not provide the diversification benefit in question.

[1] T-Test results: At α=0.05, P=0.47, t=1.96.

[2] Atwill, Timothy. “Proxy Battle: Emerging Markets Are Note a Substitute for Commodities.” Journal of Wealth Management 16.4(2014):33-42.