The Effectiveness of Asset Classes in Hedging Risk

Abstract

Garcia-Feijoo, Jensen, and Johnson evaluate the effectiveness of several asset classes in the hedging of portfolio risk over the 1970–2010 period. Of the alternative assets examined, commodities offer the greatest diversification potential due to their very low correlation with stock and bond returns. Furthermore, while the diversification benefits of many asset classes diminish during periods of extreme market movements, the benefits of commodities remain strong. Overall, they find robust support for the hedging potential of commodities, but they present three caveats to this view. First, relative to the other commodities, industrial metals offer much less diversification potential for equity investors. Second, commodities serve as considerably more effective hedges during periods when Federal Reserve monetary policy is tight (i.e., when inflationary concerns are elevated). Third, relative to the other commodities, precious metals provide equity investors with a more consistent hedge across alternative inflationary environments.