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.
Confidence in anomaly's validity
Backtest period from source paper
Notes to Confidence in Anomaly's Validity
Period of Rebalancing
Notes to Indicative Performance
per annum, for 1 month holding period and 12 month ranking period, data from table 1
Notes to Period of Rebalancing
Number of Traded Instruments
Notes to Estimated Volatility
Notes to Number of Traded Instruments
Notes to Maximum drawdown
Notes to Complexity Evaluation
Simple trading strategy
Create a universe of tradable commodity futures. Rank futures performance for each commodity for the last 12 months and divide them into quintiles. Go long on the quintile with the highest momentum and go short on the quintile with the lowest momentum. Rebalance each month.
Hedge for stocks during bear markets
Yes - A commodity momentum strategy is a cornerstone of trend-following CTA funds and, as such, is an excellent candidate for an uncorrelated strategy and very often a hedge to equity market factor. We recommend, for example, Blitz, De Groot – “Strategic Allocation to Commodity Factor Premiums” for more information regarding using commodity factor portfolios in asset allocation.
Strategy's implementation in QuantConnect's framework