The Tactical and Strategic Value of Commodity Futures

1
The Tactical and Strategic Value of Commodity
Futures
Q Group Spring Seminar 03-05 April 2005 Key
Largo

• Claude B. Erb
  Campbell R. Harvey
• TCW, Los Angeles, CA USA
  Duke University, Durham, NC USA
• 
  NBER, Cambridge,
  MA USA

2
Commodity Futures Summary Statistics

• Since 1969, the Goldman Sachs Commodity Index
  (GSCI) has outperformed the SP 500
• What does this imply about our asset allocation
  decision to commodity futures?
• The critical question is whether the past will
  repeat.

3
Figure 1Return and RiskDecember 1969 to May 2004
50 SP 500 50 GSCI
GSCI Total Return
SP 500
Intermediate Treasury
3-month T-Bill
Inflation
Note GSCI inception date is December 1969.
During this time period, the SP 500 and the GSCI
had a monthly return correlation of -0.03. GSCI
is collateralized with 3-month T-bill.
4
Commodity Futures Different Indices

• GSCI Production weighted
• Dow-Jones AIG Production and liquidity
• Reuters-CRB Equal weighted

5
Figure 2Market Value of Long Open Interest As
May, 2004
Data Source Bloomberg
6
Figure 3 Return and RiskJanuary 1991 to May 2004
Wilshire 5000
GSCI
DJ AIG
Lehman US Aggregate
MSCI EAFE
3-month T-Bill
CRB
Comparison begins in January 1991 because this is
the initiation date for the DJ AIG Commodity
Index. Cash collateralized returns
7
Table 1The Composition of Commodity Indices (as
of May 2004)
Data Source Goldman Sachs, Dow Jones AIG
8
Commodity Futures Beware of Indexes

• GSCI Traded since 1992
• But performance backfilled to 1969.
• 1969-1991, compound annual return15.3 beating
  the SP 500 return of 11.6
• 1992-2004, compound return of 7 while SP 500
  was 10.4

9
Commodity Futures Beware of Indexes

• DJ-AIG Traded since 1998
• But performance backfilled to 1991.
• 1991-1998, compound annual return4.1 beating
  the GSCI which only had 0.5

10
Commodity Futures Beware of Indexes

• CRB Traded since 1986
• But performance backfilled to 1982.

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Table 2Historical Excess ReturnsDecember 1982
to May 2004
12
Table 2Historical Excess ReturnsDecember 1982
to May 2004
13
Table 2Historical Excess ReturnsDecember 1982
to May 2004
14
Table 3Excess Return CorrelationsMonthly
observations, December 1982 to May 2004
15
Figure 4Term Structure of Commodity PricesMay
30, 2004
Crude Oil
Backwardation
Gold
Contango
16
Commodity Futures Roll Returns

• The excess return consists of a spot return and a
  roll return.
• The spot return is the change in the price of the
  nearby futures contract.
• Since futures contracts have an expiration date
  investors who want to maintain a commodity
  futures position have to periodically sell an
  expiring futures contract and buy the next to
  expire contract.

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Commodity Futures Roll Returns

• This is called rolling a futures position.
• If the term structure of futures prices is upward
  sloping, an investor rolls from a lower priced
  expiring contract into a higher priced next
  nearest futures contract.
• If the term structure of futures prices is
  downward sloping, an investor rolls from a higher
  priced expiring contract into a lower priced next
  nearest futures contract.
• This suggests that the term structure of futures
  prices drives the roll return.

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Commodity Futures Roll Returns

• The excess return for gold futures was about
  -5.7 per annum, the spot price return was -0.8
  and the roll return was about -4.8.
• The roll return was negative because the gold
  futures market is almost always in contango.
• The average spot return of heating oil and gold
  futures was close to zero. The 11.2 excess
  return difference between heating oil and gold
  was largely driven by a 9.5 difference in roll
  returns.
• The 1.7 difference in spot returns was a
  relatively minor source of the overall return
  difference between heating oil and gold.
• This example illustrates that excess returns and
  spot returns need not be the same if roll returns
  differ from zero

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Figure 5Excess and Spot ReturnsDecember 1982 to
May 2004
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Commodity Futures Normal Backwardation?

• How important have roll returns been in
  explaining the cross-section of individual
  commodity futures excess returns?
• Long-only normal backwardation suggests that
  commodity futures excess returns should be
  positive, for both backwardated and contangoed
  commodity futures.
• In fact, Gorton and Rouwenhorst (2004) suggest
  that under normal backwardation there should be
  no relationship between the term structure of
  commodity futures prices and the returns from
  investing in commodity futures.

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Figure 6Excess Returns and Roll Returns
December 1982 to May 2004
Copper
Heating Oil
Live Cattle
Cotton
Soybeans
Sugar
Live Hogs
Wheat
Gold
Corn
Coffee
Silver
22
Figure 7 Consumer Price Index Composition, 2003
Note
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Commodity Futures Inflation Hedge?

• Inflation
• Unexpected Inflation
• Expected Inflation
• Change in Inflation

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Figure 8GSCI Excess Return and Unexpected
InflationAnnual Observations, 1969 to 2003
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Table 4Commodity Excess Return And Change in
Annual InflationAnnual Observations, 1982 to 2003
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Commodity Futures Inflation Hedge?

• Variation across commodities
• Link to roll return

27
Figure 9Unexpected Inflation Betas and Roll
Returns December 1982 to December 2003
Energy
Copper
Heating Oil
Industrial Metals
GSCI
Live Hogs
Live Cattle
Livestock
Sugar
Corn
Non-Energy
Agriculture
Coffee
Cotton
Soybeans
Gold
Wheat
Precious Metals
Silver
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Commodity Futures What is the Risk?

• Risk Factors
• Market
• Term
• Default
• SML
• HML
• Change in FX

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Table 5Unconditional Commodity Futures
BetasMonthly Observations, December 1982 to May
2004
Note , , significant at the 10, 5 and
1 levels.
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Commodity Futures Diversification Return

• Need to rebalance portfolio
• What is the return due to rebalancing?

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Table 6The mechanics of the diversification
return
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Figure 10Commodity Futures Index Diversification
Returns
33
Commodity Futures Strategic Allocation

• Mean variance analysis
• What do you collateralize with?

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Figure 11Strategic Asset AllocationDecember
1969 to May 2004
SP 500 Collateralized Commodity Futures
2
Intermediate Bond Collateralized Commodity Futures
GSCI (Cash Collateralized Commodity Futures)
SP 500
1
60 SP 500 40 Intermediate Treasury
Intermediate Treasury
35
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36
Figure 11Strategic Asset AllocationDecember
1969 to May 2004
SP 500 Collateralized Commodity Futures
4
Intermediate Bond Collateralized Commodity Futures
3
2
GSCI (Cash Collateralized Commodity Futures)
SP 500
1
60 SP 500 40 Intermediate Treasury
Intermediate Treasury
37
Table 7Marginal Contribution To Portfolio Sharpe
RatioMonthly Observations, December 1982 to May
2004
38
Figure 12One-Year Moving Average GSCI Excess and
Roll ReturnsDecember 1969 to May 2004
39
Figure 13Long-Term Excess Return Persistence
December 1982 to May 2004
Energy
Heating Oil
Copper
GSCI
Soybeans
Sugar
Silver
Industrial Metals
Live Cattle
Precious Metals
Coffee
Gold
Livestock
Non-Energy
Agriculture
Cotton
Corn
Wheat
Live Hogs
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Commodity Futures Tactical Allocation

• Figure 14 shows the pay-off to a strategy of
  going long the GSCI for one month if the previous
  one year excess return has been positive or going
  long the GSCI if the previous one year excess
  return has been negative.
• This result is stable over time.
• While the momentum effect is strongest in the
  first 13 years of the sample, the effect is
  robust in the more recent period.

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Figure 14GSCI Momentum ReturnsDecember 1982 to
May 2004
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Commodity Futures Tactical Allocation

• Table 8 illustrates the pay-off to an investment
  strategy that invests 100 of portfolio assets in
  one of four strategies cash, bonds, cash
  collateralized commodity futures or bond
  collateralized commodity futures.
• The decision rule is to invest in the strategy
  that has the highest previous twelve month
  return.

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Table 8Momentum strategies based on GSCI,
bonds, cash, and equityDecember 1969- May 2004
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Commodity Futures Tactical Allocation

• Figure 15 examines the pay-off to investing in an
  equally-weighted portfolio of the four commodity
  futures with the highest prior twelve month
  returns, a portfolio of the worst performing
  commodity futures, and a long/short portfolio
  fashioned from these two portfolios.

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Figure 15Individual Commodity Momentum
PortfoliosDecember 1982 to May 2004
Trading strategy sorts each month the 12
categories of GSCI based on previous 12-month
return. We then track the four GSCI components
with the highest (best four) and lowest (worst
four) previous returns. The portfolios are
rebalanced monthly.
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Commodity Futures Tactical Allocation

• We now consider a variation of the strategy that
  uses the sign of the previous 12-months return.
  We create an insurance providing proxy
  portfolio by buying commodities that have had a
  positive return over the past 12 months and
  selling those that have had a negative return.
• We use the insurance term because going long a
  backwardated commodity provides price insurance
  as does going short a contangoed commodity. It is
  possible that in a particular month that all past
  returns are positive or negative.

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Figure 16Individual Commodity Momentum Portfolio
Based on the Sign of the Previous ReturnDecember
1982 to May 2004
Trading strategy is an equally weighted portfolio
of twelve components of the GSCI. The portfolio
is rebalanced monthly. The Providing Insurance
portfolio goes long those components that have
had positive returns over the previous 12 months
and short those components that had negative
returns over the previous period.
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Commodity Futures Tactical Allocation

• When the price of the nearby GSCI futures
  contract is greater than the price of the next
  nearby futures contract (when the GSCI is
  backwardated), we expect that the long only
  excess return should, on average, be positive.
• Table 9 uses the information in the term
  structure.

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Table 9Using the Information in the GSCI Term
Structure for a Tactical StrategyJuly 1992 to
May 2004
50
Figure 17Individual Commodity Term Structure
PortfolioDecember 1982 to May 2004
Trading strategy is an equally weighted portfolio
of twelve components of the GSCI. The portfolio
is rebalanced monthly. The Long/Short portfolio
goes long those six components that each month
have the highest ratio of nearby future price to
next nearby futures price, and the short
portfolio goes short those six components that
each month have the lowest ratio of nearby
futures price to next nearby futures price.
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Commodity Futures Conclusion

• Myths and Reality

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Figure 11Strategic Asset AllocationDecember
1969 to May 2004
SP 500 Collateralized Commodity Futures
4
Intermediate Bond Collateralized Commodity Futures
3
2
GSCI (Cash Collateralized Commodity Futures)
SP 500
1
60 SP 500 40 Intermediate Treasury
Intermediate Treasury
53
Table XXXXXXLiability Betas and Hedging
CreditsFebruary 1997 to May 2004
54
Figure 4 Average Cross Correlations of Index
ComponentsDecember 1993 to May 2004
55
Table 4Commodity Excess Return and Change in
Annual InflationAnnual Observations, 1982 to 2003
Oct 25 2004 Revised Non-overlapping Bls
dec-to-dec cpi
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Table X No longer usedSensitivity to Inflation
Linked Bond ReturnsMonthly Excess
ReturnsFebruary 1997 to May 2004
57
Figure XXNo longer usedThe Economist
Industrial Commodity Price Index
Cashin, P. and McDermott, C.J. (2002), 'The
Long-Run Behavior of Commodity Prices Small
Trends and Big Variability', IMF Staff Papers 49,
175-99.