The Strategic and Tactical Value of Commodity Futures

Abstract

Investors face numerous challenges when seeking to estimate the prospective performance of a longonly investment in commodity futures. For instance, historically, the average annualized excess return of the average individual commodity futures has been approximately zero and commodity futures returns have been largely uncorrelated with one another. The prospective annualized excess return of a rebalanced portfolio of commodity futures, however, can be "equity-like." Some security characteristics (such as the term structure of futures prices) and some portfolio strategies have historically been rewarded with above-average returns. It is important to avoid naive extrapolation of historical returns and to strike a balance between dependable sources of return and possible sources of return.

Should investors have the same long-term return expectations for portfolios of commodity futures as they might have for equities? Naive extrapolation of history suggests the answer is "yes." However, extrapolating past performance into the future is often dangerous. The challenge for investors contemplating a long-only investment in commodity futures is to develop a framework for thinking about prospective returns. Such a framework requires an examination of the historical returns of individual commodity futures and portfolios of commodity futures. It also requires an analysis of the drivers of these returns.

We summarize the research we have carried out and the research of others into the role of commodity futures in investment portfolios. Several key findings result from this research. The average compound (geometric) excess return of the average individual commodity futures contract has historically been close to zero. This finding raises an important question for investors considering a long-only investment in commodity futures: How can a commodity futures portfolio have "equity-like" returns when the average returns of the portfolio's constituents have been close to zero? Two answers are revealed by our research.

First, portfolios of commodity futures that periodically rebalance may have equity-like excess returns. The rebalancing return is attributable to portfolio diversification, not to seemingly fundamental influences, such as the rate of inflation, economic growth, or risk premiums. The rebalancing return, or diversification return, is a relatively predictable source of portfolio return.

Second, portfolios of commodity futures that overweight those commodity futures with relatively high returns may produce equity-like excess returns. Of course, finding securities with above-average returns is not an easy task. In the search for above-average returns, investors can pursue two potentially return-enhancing strategies.

One strategy is to turn to security characteristics that in the past have been associated with above-average returns. One such characteristic for commodity futures is the term structure of futures prices, which has historically been highly correlated with the cross-sectional dispersion of returns among individual commodity futures. That is, commodity futures with the relatively more attractive term-structure characteristics have had higher returns than commodity futures with the relatively less-attractive term-structure characteristics. The term structure of commodity futures prices allows investors, with the benefit of hindsight, to identify commodity futures that performed well in the past. Of course, an investor faces the risk that the historically observed payoff from investing in commodity futures with above-average term-structure characteristics will not persist in the future.

Another approach is to pursue a momentum strategy. Historically, a payoff has been available from investing in commodity futures with past relatively high returns.

Finally, a diversified portfolio of commodity futures seems to be an excellent diversifier of a traditional stock and bond portfolio but is a questionable hedge of inflation and pension liabilities.