Commodity Futures

Can commodities still be useful for portfolio diversification, despite their recent poor aggregate return, high volatility and elevated return correlations with other asset classes? In the May 2013 version of their paper entitled “Strategic Allocation to Commodity Factor Premiums”, David Blitz and Wilma de Groot examine the performance and diversification power of the commodity market portfolio and of alternative commodity momentum, carry and low-risk (low-volatility) portfolios. They define the commodity market portfolio as the S&P GSCI (production-weighted aggregation of six energy, seven metal and 11 agricultural commodities). The commodity long-only (long-short) momentum portfolio is each month long the equally weighted 30% of commodities with the highest returns over the past 12 months (and short the 30% of commodities with the lowest returns). The commodity long-only (long-short) carry portfolio is each month long the equally weighted 30% of commodities with the highest annualized ratios of nearest to next-nearest futures contract price (and short the 30% of commodities with the lowest ratios). The commodity long-only (long-short) low-risk portfolio is each month long the equally weighted 30% of commodities with the lowest daily volatilities over the past three years (and short the 30% of commodities with the highest volatilities). They also consider a combination that equally weights the commodity momentum, carry and low-risk portfolios. For comparison to U.S. stocks, they use returns of long-only, equally weighted “big-momentum” and “big-value” (comparable to commodity carry) stock portfolios from Kenneth French, and a similarly constructed “big-low-risk” stock portfolio. For comparison with bonds, they use the total return of the JP Morgan U.S. government bond index. For all return series and allocation strategies, they ignore trading frictions. Using daily and monthly futures index levels and contract prices for the 24 commodities in the S&P GSCI as available during January 1979 through June 2012, along with contemporaneous returns for a broad sample of U.S. stocks, they find that: Keep Reading

It is plausible that crude oil as a dominant energy commodity has return characteristics substantially different from those of other commodities and asset classes, and therefore represents a good diversification opportunity. To check, we add the United States Oil Fund (USO) to the following mix of asset class proxies (the same used in “Simple Asset Class ETF Momentum Strategy”):

PowerShares DB Commodity Index Tracking (DBC)
iShares MSCI Emerging Markets Index (EEM)
iShares MSCI EAFE Index (EFA)
SPDR Gold Shares (GLD)
iShares Russell 1000 Index (IWB)
iShares Russell 2000 Index (IWM)
SPDR Dow Jones REIT (RWR)
iShares Barclays 20+ Year Treasury Bond (TLT)
3-month Treasury bills (Cash)

First, per the findings of “Asset Class Diversification Effectiveness Factors”, we measure the average monthly return for USO and the average pairwise correlation of USO monthly returns with the monthly returns of the above assets. Then, we compare cumulative returns and basic monthly return statistics for equally weighted (EW), monthly rebalanced portfolios with and without USO. We ignore rebalancing frictions, which would be about the same for the alternative portfolios. Using adjusted monthly returns for USO and the above nine asset class proxies as available from May 2006 (first return available for USO) through April 2013 (84 monthly returns), we find that: Keep Reading

A subscriber suggested testing the diversification power of iPath DJ-UBS Copper ETN (JJC) as a distinct asset class. To check, we add JJC to the following mix of asset class proxies (the same used in “Simple Asset Class ETF Momentum Strategy”):

PowerShares DB Commodity Index Tracking (DBC)
iShares MSCI Emerging Markets Index (EEM)
iShares MSCI EAFE Index (EFA)
SPDR Gold Shares (GLD)
iShares Russell 1000 Index (IWB)
iShares Russell 2000 Index (IWM)
SPDR Dow Jones REIT (RWR)
iShares Barclays 20+ Year Treasury Bond (TLT)
3-month Treasury bills (Cash)

First, per the findings of “Asset Class Diversification Effectiveness Factors”, we measure the average monthly return for JJC and the average pairwise correlation of JJC monthly returns with the monthly returns of the above assets. Then, we compare cumulative returns and basic monthly return statistics for equally weighted (EW), monthly rebalanced portfolios with and without JJC. We ignore rebalancing frictions, which would be about the same for the alternative portfolios. Using adjusted monthly returns for JJC and the above nine asset class proxies from November 2007 (first return available for JJC) through April 2013 (66 monthly returns), we find that: Keep Reading

Can investors rely on commodities to protect against inflation? In their May 2013 paper entitled “Commodities as Inflation Protection”, Andrew Marks, George Crawford and Jim Kyung-Soo Liew examine the belief that commodities represent an intrinsic store of value that hedges against inflation. They use spot prices for commodities because these prices have long histories. They use the U.S. Consumer Price Index (CPI) as the measure of inflation. However, CPI is an aggregate of the prices of many finished goods and services adjusted to reflect a government model of the actual cost of living, so it may not be possible to create a portfolio that tracks its composition. Commodities (such as crops, crude oil and precious metals), as raw inputs to these goods and services, may rise in price with the CPI, and the proliferation of futures contracts and related exchange-traded funds (ETF) makes investing in commodities accessible. Using monthly spot prices for 45 individual commodities and 14 aggregating indexes during January 1960 through December 2012 (53 years), with focus on five subperiods involving relatively high inflation, they find that: Keep Reading

Do time series carry (intrinsic value) and time series momentum (intrinsic momentum) strategies work across asset classes? What drives their returns, and how do they interact? In the January 2013 very preliminary version of their paper entitled “The Returns to Carry and Momentum Strategies: Business Cycles, Hedge Fund Capital and Limits to Arbitrage”, Jan Danilo Ahmerkamp and James Grant examine intrinsic value strategy and intrinsic momentum strategy returns for 55 worldwide futures contract series spanning equities, bonds, currencies, commodities and metals, including the effects of business cycle/economic conditions and institutional ownership. They study futures (rather than spot/cash) markets to minimize trading frictions and avoid shorting constraints. They calculate futures contract returns relative to the nearest-to-maturity futures contract (not spot/cash market) price. The momentum signal is lagged 12-month cumulative raw return. The carry (value) signal is the lagged 12-month average normalized price difference between second nearest-to-maturity and nearest contracts. They test strategies that are each month long (short) contracts with positive (negative) value or momentum signals. They also test a combination strategy that is long (short) contracts with both value and momentum signals positive (negative). For comparability of assets, they weight contract series within multi-asset portfolios by inverse volatility, estimated as the average absolute value of daily returns over the past three months. Their benchmark is a long-only portfolio of all contracts weighted by inverse volatility. Using daily settlement prices for the nearest and second nearest futures contracts of the 55 series (10 equities, 12 bonds, 17 commodities, nine currencies and seven metals) as available during 1980 through 2012, they find that: Keep Reading

In her 2012 book A Trader’s First Book on Commodities: An Introduction to The World’s Fastest Growing Market (2nd Edition), author Carley Garner hopes to convey “the realization that anything is possible in the commodity markets. Never say ‘never’ — if you do, you will eventually be proven wrong. Additionally, trading the markets is an art, not a science. Unfortunately, there are no black-and-white answers, nor are there fool-proof strategies — but that does not mean that there aren’t opportunities.” Her further hope is that “this book is the first step in your journey toward victory in the challenging, yet potentially rewarding, commodity markets.” Some notable points from the book are: Keep Reading

Wars both consume crude oil and potentially disrupt supplies. Do they reliably drive up oil price? In their November 2012 paper entitled “Crude Oil as a Safe Haven Asset in Times of War”, Tomasz Wisniewski and Ayman Omar examine the behaviors of crude oil price and stock market indexes around severe international crises and wars. They construct a sample of crises from the July 2010 version of the International Crisis Behavior (ICB) database, excluding events scoring below “6” on the severity scale (such as protests, diplomatic sanctions and withholding economic aid). They also extract a war subsample (border clash/crossing by military forces, invasion of air space, sea/air military operations and large-scale military attacks/bombing). They use the Cushing, Oklahoma West Texas Intermediate (WTI) spot price as crude oil price, but also test the Brent spot price as a robustness check. They consider S&P 500 and MSCI World as representative stock market indexes. They define the crisis/war impact interval as 50 trading days before through 50 trading days after outbreak. They define the effect of a crisis/war on price as the “abnormal” return compared to price behavior during the 150 trading days prior to the impact interval. Using daily crude oil spot price and stock index levels around 64 instances of severe international crises and 43 wars during January 1987 through December 2007, they find that: Keep Reading

Which asset class best hedges inflation? In the September 2012 draft of his book chapter entitled “‘Real’ Assets”, Andrew Ang examines the behaviors of the following assets commonly thought to hold their value during times of high inflation (“real” assets): inflation-linked bonds, commodities, real estate and U.S. Treasury bills (T-bill). He focuses on inflation as year-over-year change in the U.S. Consumer Price Index for all urban consumers and all items, but considers also inflation rates for medical care and higher education. He distinguishes inflation hedging (measured by correlation of returns and inflation) from long-run asset class performance. Using asset class proxy returns and U.S. inflation rates as available through 2011, he finds that: Keep Reading

Are commodities effective diversifiers for stocks and bonds? In his September 2012 paper entitled “Commodity Investments: The Missing Piece of the Portfolio Puzzle?”, Xiaowei Kang examines the diversification properties of commodity indexes relative to stock and bond indexes. He focuses on the widely used S&P GSCI, composed of 24 commodities with liquid futures markets weighted by world production value. He also considers the S&P GSCI Dynamic Roll, designed to suppress negative roll returns by rolling into longer-dated (nearby) futures contracts when a commodity’s term structure is in contango (backwardation). Using monthly levels of these indexes, MSCI World (to represent stocks) and Barclays Global Aggregate Bond Index (to represent bonds), along with contemporaneous U.S. Treasury bill yields to calculate excess returns, from as early as December 1970 through June 2012, he finds that: Keep Reading

Are managed futures programs good portfolio diversifiers? In his September 2012 paper entitled “Revisiting Kat’s Managed Futures and Hedge Funds: A Match Made in Heaven”, Thomas Rollinger updates prior research exploring the diversification effects of adding managed futures to traditional portfolios of stocks and bonds and to portfolios including stocks, bonds and hedge funds. His proxies for the four asset classes are: (1) for stocks, the S&P 500 Total Return Index; (2) for bonds, the Barclays U.S. Aggregate Bond Index; (3) for hedge funds, the HFRI Fund Weighted Composite Index; and, (4) for managed futures programs, the Barclay Systematic Traders Index (focused on systematic trend-following strategies). He assumes monthly (frictionless) portfolio rebalancing. Using monthly returns for the four asset class indexes during June 2001 through December 2011, he finds that: Keep Reading