Term Structure Effect in Commodities

Commodity futures have become widespread vehicles among various investors and traders. Both past research and practice have shown that commodities can be used for strategic and tactical asset allocations. The strategic appeal of commodity indices comes from their equity-like return, their inflation-hedging properties, and their role for risk diversification. Keynes (1930) and Cootner (1960) put forward the idea that commodity futures prices depend on the net positions of hedgers. This can be viewed as a form of insurance — producers, and consumers of the underlying commodity transfer the risk of price fluctuations to speculators. Naturally, speculators are willing to undertake this risk in the hope of a large positive return.

The term structure of commodity futures can have two forms. Firstly, the increase in the futures price as maturity approaches is referred to as normal backwardation and secondly, the decrease in the futures price as maturity approaches is traditionally referred to as contango. Both normal backwardation and contango arise as a result of the inequality between the long and short positions of hedgers, which require the intervention of speculators to restore equilibrium. Therefore commodity futures returns are directly related to the propensity of hedgers to be net long or net short. Aforementioned leads to a simple design of an active strategy that buys mostly backwardated contracts and shorts mostly contangoed contracts – the strategy which exploits the term structure in commodities.

Last but not least, similar results can be found in the paper of Shwayder and James: “Returns to the Commodity Carry Trade”. In their speculation strategy, an investor buys commodity futures if the underlying commodity market is in backwardation and sells commodity futures if the underlying commodity market is in contango. Moreover, they have demonstrated that this strategy, if applied to a portfolio of 28 commodities, is characterized by high returns and high Sharpe ratios, which are uncorrelated with conventional risk factors.

Fundamental reason

The main idea is based on the theory of Keynes (1930) and Cootner (1960) – the commodity futures prices depend on the net positions of hedgers. Producers or consumers of the underlying commodity transfer the risk of price fluctuations to speculators, who are willing to undertake this risk in the hope of a large positive return. If the supply by short hedgers exceeds the demand by long hedgers (namely, hedgers are net short), the futures price today has to be a downward-biased estimate of the futures price at maturity.
Moreover, from the practical point of view, term-structure strategies are connected with various interesting properties for potential investors. To be more precise, term-structure strategies come with lower maximum drawdowns, higher maximum run-ups, and both lower minimum and higher maximum 12-month rolling returns than the benchmark. Additionally, the reward-to-risk and Sortino ratios of all seven profitable active term-structure strategies in the paper, exceed those of the passive strategy or the benchmark. Hence, the high average returns of the term structure strategies appear to more than compensate investors for the increase in volatility and downside risk that they bear relative to the passive benchmark. Interestingly, the returns of the long-short portfolios follow the ups and downs of the S&P GSCI but are unrelated to the S&P500, which offers a way for the diversification of equity portfolios.
Erb and Harvey in “The Tactical and Strategic Value of Commodity Futures” state that historically, the average annualized excess return of individual commodity futures has been approximately zero, and commodity futures returns have been mostly uncorrelated with one another. However, the prospective annualized excess return of a rebalanced portfolio of commodity futures can be equity-like. Specific security characteristics, such as the term structure of futures prices, and some portfolio strategies have historically been rewarded with above-average returns. An interesting view on this topic can also be found in the work of Durr and Voegeli: Structural Properties of Commodity Futures Term Structures and Their Implications for Basic Trading Strategies. Time series of commodity prices and returns were analyzed by means of static and rolling principal component analysis. The authors have found high stability of the principal components and their explanatory power over time. The first component identified as a level factor is paramount for the interpretation of term structure dynamics for most underlying. This result suggests that an investor can exploit the information contained within the term structure and revealed by principal component analysis.

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Markets Traded
commodities

Financial instruments
futures

Confidence in anomaly's validity
Strong

Backtest period from source paper
1979-2004

Notes to Confidence in Anomaly's Validity

Indicative Performance
11.73%

Period of Rebalancing
Monthly

Notes to Indicative Performance

per annum, for 1 month rebalancing period


Notes to Period of Rebalancing

Estimated Volatility
23.84%

Number of Traded Instruments
10

Notes to Estimated Volatility

data from table 3


Notes to Number of Traded Instruments

Maximum Drawdown
-57.53%

Complexity Evaluation
Simple strategy

Notes to Maximum drawdown

Notes to Complexity Evaluation

Sharpe Ratio
0.49

Simple trading strategy

This simple strategy buys each month the 20% of commodities with the highest roll-returns and shorts the 20% of commodities with the lowest roll-returns and holds the long-short positions for one month. The contracts in each quintile are equally-weighted. The investment universe is all commodity futures contracts.

Hedge for stocks during bear markets

No - Term Structure (or Carry) in commodities is not such a good hedge/diversifier as a momentum factor. Bakshi, Bakshi, and Rossi’s research paper “Understanding the Sources of Risk Underlying the Cross-Section of Commodity Returns” analyzes the exposure of various commodity factor strategies and shows that the commodity Carry factor is linked to innovations in global equity return volatility. In periods where global equity volatility increases (decreases), the carry factor delivers low (high) returns. Additionally, innovations in global equity volatility can price the commodity portfolios sorted on the Carry. At the same time, we show that innovations in global equity volatility cannot price commodity portfolios sorted on momentum. The economic intuition is that the high average returns to carry is compensation for the low payoff of the strategy when volatility increases.

Source paper
Fuertes, Miffre, Rallis: Tactical Allocation in Commodity Futures Markets: Combining Momentum and Term Structure Signals
- Abstract

This paper examines the combined role of momentum and term structure signals for the design of profitable trading strategies in commodity futures markets. With significant annualized alphas of 10.14% and 12.66% respectively, the momentum and term structure strategies appear profitable when implemented individually. With an abnormal return of 21.02%, a novel double-sort strategy that exploits both momentum and term structure signals clearly outperforms the single-sort strategies. This double-sort strategy can additionally be utilized as a portfolio diversification tool. Interestingly, the abnormal performance of the double-sort portfolios cannot be explained by a lack of liquidity or data mining and is robust to transaction costs and to different specifications of the risk-return trade-off.

Strategy's implementation in QuantConnect's framework (chart+statistics+code)
Other papers
Gorton, Haiashy, Rouwenhorst: The Fundamentals of Commodity Futures Returns
- Abstract

Commodity futures risk premiums vary across commodities and over time depending on the level of physical inventories, as predicted by the Theory of Storage. Using a comprehensive dataset on 31 commodity futures and physical inventories between 1969 and 2006, we show that the convenience yield is a decreasing, non-linear relationship of inventories. Price measures, such as the futures basis (“backwardation”), prior futures returns, and prior spot returns reflect the state of inventories and are informative about commodity futures risk premiums. The excess returns to Spot and Futures Momentum and Backwardation strategies stem in part from the selection of commodities when inventories are low. Positions of futures markets participants are correlated with prices and inventory signals, but we reject the Keynesian “hedging pressure” hypothesis that these positions are an important determinant of risk premiums.

Erb, Harvey: The Tactical and Strategic Value of Commodity Futures
- Abstract

Investors face a number of challenges when seeking to estimate the prospective performance of a long-only investment in commodity futures. For instance, historically, the average annualized excess return of individual commodity futures has been approximately zero and commodity futures returns have been largely uncorrelated with one another. However, the prospective annualized excess return of a rebalanced portfolio of commodity futures can be equity-like. Certain security characteristics, such as the term structure of futures prices, and some portfolio strategies have historically been rewarded with above average returns. Avoiding naïve extrapolation of historical returns and striking a balance between dependable sources of return and possible sources of return is important. This is the unabridged version of our 2006 publication in the Financial Analysts Journal.

Shwayder, James: Returns to the Commodity Carry Trade
- Abstract

This paper investigates the returns to the commodity carry trade, a speculation strategy in which an investor buys commodity futures if the underlying commodity market is in backwardation and sells commodity futures if the underlying commodity market is in contango. We demonstrate that this strategy, if applied to a portfolio of 28 commodities, is characterized by high returns and high Sharpe ratios which are uncorrelated with conventional risk factors. Motivated by the “peso event” literature we also study the payoffs associated with the hedged commodity carry trade, a strategy in which the carry trader purchases options on commodity futures in order to limit losses. We find that the returns to the hedged carry trade are also on average large and uncorrelated with traditional risk factors, and in fact in sample are surprisingly higher than the unhedged version. We also investigate the hedging pressure hypothesis, under which returns to this sort of trade could just be compensation for insuring natural hedgers against price movements. The data here are not as clean as one would hope, but preliminary investigation does not suggest that this hypothesis can fully explain the returns to the commodity carry trade.

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.

Durr, Voegeli: Structural Properties of Commodity Futures Term Structures and Their Implications for Basic Trading Strategies
- Abstract

This paper examines the informational content of commodity futures term structures over time. Time series of commodity prices and returns are analyzed by means of static and rolling principal component analysis. We use weekly data from January 1998 to July 2009 of 23 commodity underlyings from Energy, Metals, Agriculture and Livestock. We find high stability of the principal components and their explanatory power over time. The first component identified as a level factor is paramount for the interpretation of term structure dynamics for most underlyings. This result suggests that an investor can exploit the information contained within the term structure and revealed by principal component analysis. We formulate three distinctive investment strategies based on term structure information which optimize roll yields. By creating portfolios according to a principal component ranking we significantly outperform a long-only benchmark.

Kim: Low-High Basis Factor in the Commodity Futures Market
- Abstract

We consider the profit to the “buy low-basis commodities and sell high-basis commodities” strategy as a pricing factor in the commodity futures market. We call this factor the low-high basis factor, or LHB factor, in short. We first document the significant premium accruing to the LHB factor. We then report a substantial reduction in the pricing errors of factor models. In particular, the zero-intercept hypothesis of factor models is no longer rejected by the data once the LHB factor is included in the model. Finally, we show that the time-variation in the LHB factor return can be predicted, to some extent, by the implied volatility spread. We relate our findings to Keynes’ normal backwardation theory and Kaldor’s theory of storage and convenience yield.

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.

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.

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.

Bianchi: Carry Trades and Tail Risk: Evidence from Commodity Markets
- Abstract

In this paper I document that carry trades in commodity markets are subject to potential large and infrequent losses, that is, tail risk. Also, I show that shocks to carry trades and volatility have persistent tail-specific effects which last from four to twelve weeks ahead. The main empirical results are consistent with existing theoretical models in which carry traders are subject to limited risk capacity and liquidity constraints. In this respect, I provide evidence that money managers, index traders, and more generally non-commercial traders, tend to unwind their net-long futures positions when exposed to deteriorating aggregate financial conditions and increasing market uncertainty. Methodologically, I make use of panel quantile regressions with non-additive fixed effects, which allow to identify the tail-specific effect of carry on the conditional distribution of commodity futures excess returns.

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.

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