From the May 01, 2011 issue of Futures Magazine • Subscribe!

Capturing commodity backwardation

Our strategy performance over the 2005-10 period is shown in "Long strategy returns" (below). Because it is a long-only strategy, the appropriate benchmark for comparison is the Sharpe ratio. Seven of the active strategy Sharpe ratios are equal to or higher than the buy and hold, and of the three that are lower, corn, soybeans and wheat, two are slightly lower. Also interesting, six of the seven strategies that outperform have higher mean returns than the buy and hold. Thus, even over a predominantly bull phase, several of our backwardation timing strategies are able to achieve higher mean returns, suggesting that timing backwardation has considerable economic benefit.

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The other benefit of our long flat strategies, which is more intuitive, is the reduction in volatility and drawdown. The reduction in drawdowns is particularly interesting, being lower for all commodities, and dramatically lower for copper and crude, for which the strategy Sharpe ratios are much higher than buy and hold. The equally weighted portfolio achieves a slightly higher mean, somewhat higher Sharpe ratio and a much lower maximum drawdown of 15%. This equally weighted portfolio has the second moment (volatility and drawdown) characteristics of an equity type investment, while achieving a high mean.

We now focus on the 2008-10 period, covering the period of the financial crisis. "Crisis performance" (below) shows the performance of the buy-and-hold strategy over this period, and the decline is evident. Three of the 10 commodities have negative returns and the Sharpe ratio of the equally weighted portfolio is 0.51. The maximum drawdowns all occurred over this period, and the average volatilities are higher. Not all of the commodities performed worse, though, with sugar achieving a higher Sharpe ratio over this period.

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