Unhedged Commodities Fall Short in Crises

By Scott Blythe

Commodities held the spotlight in the 1970s, a time of high inflation. Two decades later, they sank way down on the investment charts, with gold challenged to maintain $250 an ounce and oil plummeting to $9 a barrel. But the 2000s have been a period of higher-floating commodity prices–easy money it would seem.

But there’s difficulty in extracting alpha from commodities. Simply buying commodities long, using monthly futures contracts as many index funds do, is to buy into contango and miss the roll yield. The indexes may report real long-term price changes, but the mechanics of investing lead to, let’s call it a tracking error. Some pigs got lost on the way to market. Don’t worry, we’ll find them before the wolves do.

Is there a better way?

In a recent paper, Joëlle Miffre, from EDHEC’s business school in Nice, France, sums up the investment case for a long-short commodity portfolio. “[T]he strategic decision to include commodity futures in a well-diversified portfolio does not solely depend on the risk premium of these long-short portfolios. It is also driven by a desire for risk diversification.”

Can investors have both? Alpha returns at lower risk? Miffre thinks so. But you have to insure against those piggies that didn’t quite get the market.

Analyzing the data, he reports that “with Sharpe ratios that are on average four times as high, the performance of long-short portfolios by far exceeds that of long-only commodity indices (equally-weighted portfolio of 27 commodity futures and S&P-GSCI). Second, the conditional volatility of long-short commodity portfolios is found to be lower than that of the S&P-GSCI. It is also found to rise by less than that of the S&P-GSCI in periods of increased volatility in equity markets and to fall in periods of increased volatility in fixed income markets (when that of long-only indices actually rises).”

He maps his results in the chart below:

A key problem is that investors expect commodity outperformance during times of market stress, when real assets seem to be a kind of store of value. They’re not, of course, and investors expecting outperformance during the 2008 financial crisis didn’t find it, at least on the long side. As Miffre notes:

“[I]n periods of high volatility in equity markets, the conditional correlations between the S&P500 index and the long-short commodity portfolios based on the positions of hedgers and speculators is found to decrease. This is good news to equity investors as it is precisely when the volatility of equity markets is high (e.g., following the demise of Lehman Brothers) that the benefits of diversification are most appreciated. In contrast, the conditional correlation between long-only commodity indices and equity indices rises with the volatility of the S&P500 index, suggesting that the risk reduction that comes from diversification prevails less when needed most; namely, during equity market downturn.”

The diversification advantage also works in times of fixed income volatility. But again, only if it’s a long-short play. “[T]he Sharpe ratio of Barclays Capital bond index (at 0.6631) systematically exceeds the Sharpe ratios of long-only commodities and those of long- only commodity indices. The Sharpe ratio of the S&P500 index (at 0.2401) exceeds that of 22 long-only commodities and that of both long-only commodity indices” — the long-only commodity indexes being the S&P GSCI and Miffre’s equally weighted commodity index of 27 contracts (one of which has now gone to hog heaven, since Chicago has discontinued trading in pork bellies).

How would a mechanical long-short commodity strategy work. Miffre arrives at what he calls hedging pressure. “A hedging pressure of 0.2 for hedgers means that over the previous week 20% of hedgers were long and thus 80% were short, a sign of a backwardated market. Vice versa, a hedging pressure of 0.2 for speculators means that over the previous week 20% of speculators were long and thus 80% were short, a sign of a contango market.”

Such statistics are significant because they provide trading signals – long or short — not based on the fundamental demand for the commodity, but on what traders believe about the commodity – hedgers and speculators. It does make for diversification in crisis times, as the chart below shows:

Which must make for interesting discussion at the traders’ breakfast table. Would you like bacon with your eggs, or an actively traded soybean substitute?

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