According to the researches of Bodie and Rosansky, commodity futures are excellent portfolio diversifiers, and some of them are even an effective hedge against inflation. Although the short-term price continuation was identified in equity markets by Jegadeesh and Titman (1993, 2001), the theory still holds if we consider a different asset class – commodities. In the world of commodities, the momentum strategies buy the commodity futures that outperformed in the recent past and sell the commodity futures that under-performed and hold the relative-strength portfolios for up to 12 months. Additionally, it was proved that investors could use various combinations of ranking periods and holding periods and these strategies would still be profitable. Moreover, there are some strong rationales for implementing momentum strategies in commodity futures markets. Firstly, commodity-based long-short strategies minimize transaction costs. Nextly, the commodity momentum strategies trade liquid contracts with nearby maturities and commodities do not have any troubles with the short-selling restrictions that are often imposed in equity markets. Adding the fact, that this strategy only focuses on 31 commodity futures (as opposed to hundreds or thousands of stocks), it is very unlikely that the abnormal returns identified by the paper would be eroded by the costs of implementing the momentum strategy or will be a compensation for lack of liquidity. Momentum returns are also found to have low correlations with the returns of traditional asset classes, making the commodity-based relative-strength strategies good candidates for inclusion in well-diversified portfolios.
Similar results can also be found in other papers, for example Switzer and Jiang in the “Market Efficiency and the Risks and Returns of Dynamic Trading Strategies with Commodity Futures”, have found that 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. A good point is also in the work of Blitz and De Groot: “Strategic Allocation to Commodity Factor Premiums”. The authors have confirmed 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. They have also found 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.
Firstly, commodities momentum returns are found to be related to the propensity of commodity futures markets to be in backwardation or contango. The results of the paper suggest that momentum strategies buy backwardated contracts and sell contangoed contracts. This implicitly suggests that a momentum strategy that consistently trades the most backwardated and contangoed contracts is likely to be profitable. The aforementioned leads to a thought that the momentum profits in commodity futures markets are linked to an economic rationale related to Keynes (1930) and Hicks (1939) theory of normal backwardation. On the other hand, it was denied that the momentum profits are compensation for risk (whether it is constant or time-dependent). Interestingly, the momentum returns are also found to have low correlations with the returns of traditional asset classes, making the commodity-based relative-strength strategies good candidates for inclusion in well-diversified portfolios.
Switzer and Jiang in the “Market Efficiency and the Risks and Returns of Dynamic Trading Strategies with Commodity Futures” states that 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. Moreover, profits from active strategies based on winner and loser portfolios are partly conditioned on term structure and net hedging pressure effects. Last but not least, the functionality also stems from the perks we have previously mentioned – liquidity, only 31 commodities and low transaction costs all help to make this strategy profitable.
Switzer, Jiang: Market Efficiency and the Risks and Returns of Dynamic Trading Strategies with Commodity Futures
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
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
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
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
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?
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
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
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
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
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?
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
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
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
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.