Momentum Effect in Commodities

Fundamental reason

Simple trading strategy

Out-of-sample strategy's implementation/validation in QuantConnect's framework(chart, statistics & code)

Source paper

Miffre, Rallis: Momentum in Commodity Futures Markets

Abstract: The article tests for the presence of short-term continuation and long-term reversal in commodity futures prices. While contrarian strategies do not work, the article identifies 13 profitable momentum strategies that generate 9.38% average return a year. A closer analysis of the commodity futures that the momentum strategy recommends trading reveals that we buy backwardated contracts and sell contangoed contracts with high volatilities. The correlation between the momentum returns and the returns of traditional asset classes is also found to be low, making the commoditybased relative-strength portfolios excellent candidates for inclusion in well-diversified portfolios.

Other papers

• Switzer, Jiang: Market Efficiency and the Risks and Returns of Dynamic Trading Strategies with Commodity Futures

  Abstract: This paper investigates dynamic trading strategies, based on structural components of returns, including risk premia, convenience yields, and net hedging pressures for commodity futures. Significant momentum profits are identified in both outright futures and spread trading strategies when the spot premium and the term premium are used to form winner and loser portfolios. The existence of profits from active trading strategies based on momentum is consistent with behavioral finance and behavioral psychology models in which market participants irrationally underreact to information and trends. Profits from active strategies based on winner and loser portfolios are partly conditioned on term structure and net hedging pressure effects. High returns from a popular momentum trading strategy based on a ranking period of 12 months and a holding period of one month dissipate after accounting for hedging pressure effects, consistent with the rational markets model.

• Ung, Kang: Alternative Beta Strategies in Commodities

  Abstract: Alternative beta strategies can serve a variety of different investment objectives, which may include reducing volatility or achieving tilts to systematic risk exposures. It is therefore essential for investors to examine whether these strategies meet their own investment objectives and risk-taking preferences. Two main approaches to alternative beta are reviewed in this paper: the ‘risk-based approach,’ which entails reducing portfolio risk; and the ‘factor-based approach,’ which involves enhancing return through earning systematic risk premia, with a focus on the latter. Whilst alternative beta is fairly well established in equity strategy investing, it is still a nascent concept in commodities. However, as a result of investors’ pursuit of better diversified portfolios and a recognition that systematic risk factors explain the majority of returns, the development of commodity alternative beta products is gathering pace. This is not entirely unforseen, as investors now view their investment opportunity in the context of risk premia, rather than individual asset classes. From our investigation in this study, there appears to be potential benefit in allocating into alternative beta strategies as part of a portfolio’s commodity allocation, and we find that combining risk-based and factor-based commodity strategies has historically delivered higher return and lower risk than passive long-only strategies on their own. Finally, it should be borne in mind that alternative beta strategies often take substantial active risks, which are largely driven by factor exposures. Factor returns can be volatile, and all alternative beta strategies can experience considerable drawdown at times. However, as these risk factors have a low correlation with each other, it may be sensible to combine them in order to improve return and reduce risk.

• Blitz, De Groot - Strategic Allocation to Commodity Factor Premiums

  Abstract: In this study we confirm the existence of sizable momentum, carry and low-volatility factor premiums in the commodity market, and argue that investors should consider these commodity factor premiums when determining their strategic asset allocation. We find that diversified portfolios of commodity factor premiums exhibits a significantly better risk-adjusted performance than the commodity market portfolio and adds significant value to a conventional stock/bond portfolio. The traditional commodity market portfolio, on the other hand, appears to deserve little or no role at all in the strategic asset mix. Investors should therefore not postpone the consideration of alternative commodity factor premiums to a later stage of the investment process.

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

  Abstract: 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.

• Bakshi, Bakshi, Rossi: Understanding the Sources of Risk Underlying the Cross-Section of Commodity Returns

  Abstract: We show that a model featuring an average commodity factor, a carry factor, and a momentum factor is capable of describing the cross-sectional variation of commodity returns. More parsimonious one- and two-factor models that feature only the average and/or carry factors are rejected. To provide an economic interpretation, we show that innovations in equity volatility can price portfolios formed on carry with a negative risk premium, while innovations in our measure of speculative activity can price portfolios formed on momentum with a positive risk premium. Furthermore, we characterize the relation of the factors with the investment opportunity set.

• Goyal, Jegadeesh: Cross-Sectional and Time-Series Tests of Return Predictability: What Is the Difference?

  Abstract: We analyze the differences between past-return based strategies that differ in conditioning on past returns in excess of zero (time-series strategy, TS) and past returns in excess of the cross-sectional average (cross-sectional strategy, CS). We find that the return difference between these two strategies is mainly due to time-varying long positions that the TS strategy takes in the aggregate market and, consequently, do not have any implications for the behavior of individual asset prices. However, TS and CS strategies based on financial ratios as predictors are sometimes different due to asset selection.

• Benham, Walsh, Obregon: Evaluating Commodity Exposure Opportunities

  Abstract: Commodities as an asset class have been in growing demand over the last 40 years, as investors that have traditionally held portfolios of stocks and bonds seek the ‘equity-like’ returns along with diversification potential and inflation hedging characteristics available through commodities investment. However, perhaps due to their relative complexity and the large remaining disagreements in the current literature about the fundamental drivers of commodities returns, investors do not universally agree on the merits of commodity investments. This paper begins by reviewing the existing theories and fundamental drivers of returns from commodity investments to better understand the risks that commodity investors are compensated for bearing. From this perspective we will evaluate existing methods of commodity investing with a focus on why the risk premia these strategies capture are likely to persist in the future.

• Blocher, Cooper, Molyboga: Benchmarking Commodity Investments

  Abstract: While much is known about the financialization of commodities, less is known about how to profitably invest in commodities. Existing studies of Commodity Trading Advisors (CTAs) do not adequately address this question because only 19% of CTAs invest solely in commodities, despite their name. We compare a novel four-factor asset pricing model to existing benchmarks used to evaluate CTAs. Only our four-factor model prices both commodity spot and term risk premia. Overall, our four-factor model prices commodity risk premia better than the Fama-French three-factor model prices equity risk premia, and thus is an appropriate benchmark to evaluate commodity investment vehicles.

• Bianchi, Drew, Fan: Microscopic Momentum in Commodity Futures

  Abstract: Conventional momentum strategies rely on 12 months of past returns for portfolio formation. Novy-Marx (2012) shows that the intermediate return momentum strategy formed using only twelve to seven months of returns prior to portfolio formation significantly outperforms the recent return momentum formed using six to two month returns prior. This paper proposes a more granular strategy termed ‘microscopic momentum’, which further decomposes the intermediate and recent return momentum into single-month momentum components. The novel decomposition reveals that a microscopic momentum strategy generates persistent economic profits even after controlling for sector-specific or month-of-year commodity seasonality effects. Moreover, we show that the intermediate return momentum in the commodity futures must be considered largely illusory, and all 12 months of past returns play important roles in determining the conventional momentum profits.

• Chaves, Viswanathan: Momentum and Mean-Reversion in Commodity Spot and Futures Markets

  Abstract: We study momentum and mean-reversion strategies in commodity futures prices and their relationship to momentum and mean reversion in commodity spot prices. We find that momentum performs well in futures markets, but not in spot markets, and that mean-reversion performs well in spot markets, but not in futures markets. A decomposition of the basis (the slope of the term-structure of futures prices) into expected risk premiums and expected changes in spot prices helps us shed some light on the different results across the futures and spot markets. Most interestingly, we find that momentum in futures prices cannot be explained by a sustained trend in spot prices.

• Rad, Yew Low, Miffre, Faff: How Do Portfolio Weighting Schemes Affect Commodity Futures Risk Premia?

  Abstract: We examine whether and to what extent successful equities investment strategies are transferrable to the commodities futures market. We investigate a total of 7 investment strategies that involve optimization and mean-variance timing techniques. To account for the unique characteristics of the commodity futures market, we propose a novel method of classification based on momentum or term structure properties in the formation of long-short portfolios in conjunction with the quantitative strategies from the equities literature. Our strategies generate significant excess returns and risk-adjusted performances as measured by the Sharpe and Sortino ratios and the maximum drawdown. We find no significant correlation between the strategies’ excess returns and common risk factors. There is no evidence that excess returns are a compensation for liquidity risk. The strategies are robust to transaction costs and choice of model parameters and exhibit stable performance across various market environments including times of financial crises.

• Urquhart, Zhang: Do Momentum and Reversal Strategies Work in Commodity Futures? A Comprehensive Study

  Abstract: This paper investigates the performance of three different trading strategies - Jegadeesh and Titman (1993), George and Hwang (2004) and Gatev, Goetzmann and Rouwenhorst (2006) - in 29 commodity futures from January 1979 to October 2017. We find there is no significant reversal profit across 189 formation-holding windows for all the three strategies. However, there are statistical and economically significant momentum profits, and the profitability increases with the rising of formation-holding periods. The strategy of inversing the conventional Gatev, Goetzmann and Rouwenhorst (2006) is more profitable than the other two momentum strategies on a risk-adjusted basis; but the superiority declines sharply since 1998. Momentum returns are quite sensitive to market conditions but the crash of momentum returns are partly predictable. Return seasonality, risk and herding also provide partial explanation of the momentum profits.

• Geczy, Samonov: Two Centuries of Commodity Futures Premia: Momentum, Value and Basis

  Abstract: Using hand-collected data of commodity futures contracts going back to 1877, we replicate in the pre-sample history the well-documented cross-sectional commodity factor premia of momentum, value and basis. All three premia remain significantly positive in the additional 80-plus years of pre-sample data. Compared to a long-only passive basket of commodity futures, a long-only premia portfolio more than doubles its Sharpe in both the early and recent samples, suggesting a more optimal way to obtain portfolio’s commodity exposure while maintaining its beneficial inflation hedging property.

• Ilmanen, Israel, Moskowitz, Thapar, Wang: Factor Premia and Factor Timing: A Century of Evidence

  Abstract: We examine four prominent factor premia - value, momentum, carry, and defensive - over a century from six asset classes. First, we verify their existence with a mass of out-of-sample evidence across time and asset markets. We find a 30% drop in estimated premia out of sample, which we show is more likely due to overfitting than informed trading. Second, probing for potential underlying sources of the premia, we find little reliable relation to macroeconomic risks, liquidity, sentiment, or crash risks, despite adding five decades of global economic events. Finally, we find significant time-variation in factor premia that are mildly predictable when imposing theoretical restrictions on timing models. However, significant profitability eludes a host of timing strategies once proper data lags and transactions costs are accounted for. The results offer support for time-varying risk premia models with important implications for theory seeking to explain the sources of factor returns.

• Hossein Rad, Rand Low, Joelle Miffre, Robert Faf: Does sophistication of the weighting scheme enhance the performance of long-short commodity portfolios?

  Abstract: The article develops a long-short portfolio construction technique that captures the fundamentals of backwardation and contango present in commodity futures markets and simultaneously deviates from the equal-weighting scheme traditionally employed in the literature. The sophisticated weighting schemes based on risk minimization and risk timing are found to dominate the traditional naive allocation and the schemes based on utility maximization. The conclusion applies to both momentum and term structure portfolios and persists after accounting for transaction costs, lack of liquidity, various model specifications, and different sub-periods.

• Zhi Da, Ke Tang, Yubo Tao and Liyan Yang: Financialization and Commodity Markets Serial Dependence

  Abstract: Recent financialization in commodity markets makes it easier for institutional investors to trade a portfolio of commodities via various commodity-indexed products. We present several pieces of novel causal evidence that daily exposure to such index trading results in price overshoots and reversals, as reflected in a negative daily return autocorrelations, only among commodities in that index. This is because index trading propagates non-fundamental noises to all indexed commodities. We present direct evidence for such noise propagation using commodity news sentiment data.

• Nakagawa, Kei and Sakemoto, Ryuta: Prices of Risk Estimation for Commodity Factors

  Abstract: This study investigates the prices of risk in cross-sectional commodity futures portfolios using a three-pass regression approach that is robust to model specification. We find that the prices of risk for commodity basis and value factors are important, with values of 1.2% and 2.0% per month, respectively. Moreover, we observe that the commodity factors do not price cross-sectional equity portfolios, resulting in a combination of the equity market and commodity factor portfolios achieving a high Sharpe ratio. Additionally, we demonstrate that the equity market factor has recently become more strongly associated with the cross-sectional commodity futures portfolios, suggesting the effects of financialization.