Data and strategy
We consider 10 of the most liquid commodities: copper, corn, crude oil, gold, live cattle, natural gas, silver, soybeans, sugar and wheat.
The basic source for hedging pressure data is the CFTC website (www.cftc.gov). It releases the COT report each Friday at 3:30 p.m. EDT. The positions refer to the Tuesday of that week, and the date reflects that. The aggregated data, which is available at a weekly frequency since 1993, is now released under the Legacy Reports (see weekly Market Pulse).
For this analysis, we need the number of long and short positions held by commercial hedgers. Commercial hedging pressure (CHP) is the ratio of long positions to the sum of long plus short positions held by commercial hedgers.
The individual commodity futures returns and the commodity index returns are based on end-of-day prices, aggregated to a weekly frequency. The futures returns are based on the front-month contract, except for the expiry month in which the next-to-front-month contract is used. The data source is Bloomberg.
We use the notion of "relative" backwardation in designing our strategies. This means we look to go long when commercial hedging pressure is low relative to the recent past. To implement this strategy, we need to decide what constitutes the recent past and what level of hedging pressure is considered to be low. The most natural time period based on harvest and storage considerations is one year, or 52 weeks. The levels for hedging pressure are based on estimated levels for "individual backwardation" and the first strategy invests when the current hedging pressure is below this level. The second strategy uses a predictive variable that measures aggregate backwardation and invests when this level is high.
Results are based on real-time out-of-sample analysis. Because strategies are executed via futures, the notional cost is zero and the basic assumption is that the investment is fully collateralized with the value of the underlying futures contract. The strategy return is reported in excess of Treasury bills and can be interpreted as an excess return.
We first analyze the performance of buy and hold strategies for the 10 commodities as well as an equally weighted portfolio over the 2005-10 period. This six-year period incorporates a bull phase (2005 to mid 2008), a short sharp bear phase (second half of 2008) and another possibly bull phase (2009-10). Nine of the 10 individual commodities achieve positive returns as shown in "Market returns" (below), with Sharpe ratios ranging from -0.9 (Natural Gas) to 1.15 (Gold).
The equally weighted portfolio is the best overall performer in terms of Sharpe ratio because of diversification, achieving a Sharpe ratio of 1.28. Individual commodity returns are volatile, and the maximum drawdowns for eight of the 10 commodities exceed 50%, with the equally weighted portfolio having a drawdown of 48%. Thus, even in a predominantly bull phase, commodity futures returns are volatile and buy and hold investments can incur sharp losses. The Sharpe ratios are quite high over this period and higher than equity investments in many cases, but the volatility and drawdowns are considerably higher.