The last decade has seen a resurgence of interest in commodity futures as an investment class, particularly from institutional investors. Their commodity allocations have grown dramatically with total commodity-linked assets under management rising to $257 billion in 2009 from $18 billion in 2003, according to Barclays Capital.
The vast majority of these investments are linked to long-only commodity indexes, with exchange-traded funds (ETF) and exchange-traded notes (ETN) based on single commodities such as crude oil, also attracting considerable interest. Much of this popularity has been fed by the notion of the commodity supercycle as propounded by Jim Rogers. The potential for inflation hedging also has been a strong draw.
However, correlations with traditional asset classes, such as stock indexes, are rising, and issues with the shape of the futures curve have meant that indexes based on futures, as well as single commodity ETFs, have failed to capture rises in spot prices. Several markets, such as crude oil, have been in contango where the spot contract is a discount to further out contracts. This acts as a drag on returns of a long commodity portfolio. For example, owners of shares of the USO crude oil ETF lost 0.7% in 2010 because of the persistent contango, although the front-month WTI contract gained 15% over this period.
Actively seeing alpha
Although the popularity of long-only indexes remains strong, there is an increasing awareness that active approaches to commodity investing might perform better.
We can construct a new class of active dynamic strategies designed to capture normal backwardation in commodity futures markets. Normal backwardation happens when the expected futures spot price is higher than the current spot price, and hence a long position in the underlying futures contract is likely to generate a positive return.
The original hedging pressure hypothesis of Keynes (1930) was that commodity futures markets always were in normal backwardation, as they served an insurance function, allowing producers to transfer price risks to speculators who would thus earn a risk premium. The Keynesian hedging pressure hypothesis provides the theoretical justification for long-only commodity indexes and single commodity ETFs. However, the empirical evidence, both long-term and current, strongly suggests that the markets are not always in backwardation and hence capturing phases of backwardation is crucial to commodity futures investment.
Our strategies are long flat weekly rebalanced strategies, in that every week either they go long an individual commodity futures contract or do not invest. We assume the underlying position is fully collateralized, but consider the performance of the timing aspect of the strategy and do not incorporate the return due to investment in Treasury bills. The return to the strategy hence may be regarded as an excess return.
Our measure of backwardation is based on the position of large hedgers and is estimated using the Commodity Futures Trading Commission’s (CFTC) Commitment of Trader’s (COT) report. We consider two kinds of backwardation — individual and aggregate. Individual backwardation is an "intrinsic" property of a commodity, which has been shown to be a determinant of future returns. Aggregate backwardation is a more recent phenomenon and refers to the increasing correlation across different commodities, which could be the result of the increasing "financialization of commodities." Our strategies endeavor to capture both of these phenomena to decide when to invest.