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Momentum in Commodity Futures and Reversion in Spot

Posted in Commodity Futures, Momentum Investing

Do spot price trends drive commodity futures momentum strategies? In their August 2016 paper entitled “Momentum and Mean-Reversion in Commodity Spot and Futures Markets”, Denis Chaves and Vivek Viswanathan investigate the reasons for the success of cross-sectional (relative) momentum strategies and failure of cross-sectional mean reversion strategies in the commodity futures markets. They specify commodity valuation as the ratio of current price to average price ratio over the past 120 months (P/A). They specify commodity price trend as cumulative return over measurement intervals ranging from the last month to the last 66 months. Using two independent sets of 25 (with liquid futures) and 21 (without liquid futures) commodity spot price series as available since 1946 and one set of 27 commodity futures price series as available since 1965, all through 2014, they find that:

  • During 1946-2014, there is strong evidence of mean reversion in spot prices based on both P/A and past cumulative return.
    • Portfolios that are long (short) the equally weighted third of commodities with the highest (lowest) spot price P/As generate negative average returns during during each month of holding periods up to about two years.
    • Portfolios that are long (short) the equally weighted third of commodities with the highest (lowest) past cumulative spot returns generate negative average next-month spot returns for all lookback intervals except 1-3 months for one spot price sample and 1 month for the other.
    • A subsidiary 12-month seasonal cycle is evident for both approaches.
  • Conversely, during 1965-2014, commodity futures prices do not exhibit mean reversion.
    • A portfolio that is each month long (short) the equally weighted third of commodities with the highest (lowest) futures price P/As generates average gross next-month futures return 2.9%.
    • A portfolio that is each month long (short) the equally weighted third of commodities with the highest (lowest) cumulative futures returns over the past 60 months generates average gross next-month futures return 0.5%.
    • It appears that market participants anticipate spot price mean reversion and price futures accordingly.
  • Instead, during 1965-2014, there is strong evidence of momentum in commodity futures prices.
    • A portfolio that is each month long (short) the equally weighted third of commodities with the highest (lowest) cumulative futures returns over the past 12 months generates annualized average gross futures return 16.1%.
    • But the average annualized gross spot return of this same portfolio is -2.0%, indicating that spot price trend does not contribute to futures price momentum.
    • Commodity futures momentum strategies tend to buy (sell) contract series trading at a discount (premium) relative to respective spot prices.
    • Findings are similar for 1965-1989 and 1990-2014 subperiods, but weaker in the latter (annualized gross futures returns 19.1% and 13.1%, respectively).
  • The time series (intrinsic) commodity futures momentum effect is weaker and less reliable than the relative momentum effect.

In summary, evidence indicates that the success of commodity futures momentum strategies comes from their tendency to exploit futures valuations and not from underlying spot price trends.

Cautions regarding findings include:

  • Reported returns are gross, not net. Accounting for portfolio reformation costs would reduce these returns. Moreover, spot price returns do not account for storage/delivery costs that an investor would incur by buying or selling actual commodities, or from the impossibility of shorting some physical commodities.
  • Sample periods are not long in terms of independent 10-year valuation measurement intervals and long past return measurement intervals used in analyzing mean reversion, limiting reliability of associated findings.
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