New related paper to #21 - Momentum Effect in Commodities and #22 - Term Structure Effect in Commodities Monday, 13 April, 2015

#21 - Momentum Effect in Commodities
#22 - Term Structure Effect in Commodities

Authors: Zaremba

Title: Strategies Based on Momentum and Term Structure in Financialized Commodity Markets



The aim of this paper is to investigate the impact of the financialization of commodity markets on the profitability of strategies based on momentum and term structure. The performance of an array of portfolios from double-sorts on non-commercial traders’ participation, historical returns and term spreads is tested against a risk model. Both strategies reveal better performance in case of commodity markets with low financialization level and generate little profits in the markets with a significant participation of investors. The findings of this study can be used for the purposes of tactical and strategic asset allocation.

Notable quotations from the paper:


"Alas, commodity investments are not flawless despite its earlier status of the Holy Grail of financial markets. What once used to be one of the commodities’ greatest advantages might become its doom. The combination of influential publications on the benefits of commodity investing and yield seeking in low rates environment leads to an enormous influx of capital into commodity markets (Tang & Xiong, 2012; Cheng & Xiong, 2013). This process is additionally fuelled by the development of electronic trading and the emergence of passive ETFs focused on commodity markets (Irwin & Sanders, 2012).

Such significant changes result in a structural shift in the composition of market participants. Figure 1 (in the paper) presents the average percentage of reported futures contracts in various commodity futures markets held by commercial and non-commercial traders (the latter usually recognized as speculators) over the period 1986 – 2013. The participation of non-commercial traders has increased from 23% in 1986 to 45% in 2013. The growing presence and importance of financial investors in commodity markets is usually referred to as financialization (Domanski & Heath, 2007).   

It can be reasonably presumed that both aforementioned strategies, i.e. momentum and term structure investing, might be affected by the phenomenon of market financialization. First of all, in the case of term structure investing strategy, the greater number of speculators in the market might lead to a decrease in the ratio of speculators to hedgers. This, in turn, might imply a decrease in the risk premium transferred to an average non-commercial market participant. Secondly, a financialization of commodity markets might also impede the profitability of momentum strategies. A growing participation of speculators in the market  might coincide with the crowding of momentum investors who, basically follow similar trading signals. This might result in worn out momentum strategies and fading momentum profits.    

This paper contributes to the academic literature in three ways. First and foremost, it provides a fresh evidence for the validity of strategies based on momentum and term structure investing in commodity markets. Secondly, it proves that term structure strategies generate significantly higher performance results in non-financialized markets. Moreover, it supports the thesis that market financialization adversely affects momentum profits. However, results achieved in the latter case are statistically insignificant."