A Long Look at Long-Short Commodity Investing
Reports of the death of commodity futures as an asset class are greatly exaggerated. However, taking a long-short approach is required for superior risk-adjusted performance and stable diversification benefits.
By Joëlle Miffre, EDHEC-Risk Institute
THE RISE IN commodity prices over the last ten years and their recent volatility has generated considerable interest on the part of investors, regulators and policy-makers. Attracted by the prospect of robust returns,
diversification benefits, and potential for hedging inflation and macroeconomic risks, investors have increased their allocations to commodities over the period, primarily via passive investment into long- only commodity futures indices. Recent market gyrations have contributed to reviving the debate on the role of commodities in strategic and tactical asset allocation and led to an increasing recognition of the relevance of long-short dynamic strategies to capture the commodities premium in the context of highly volatile markets. The increased participation of financial investors
on commodity markets has caused concerns about the latter’s possible increased integration with traditional financial markets, which could have weakened the diversification and hedging benefits from commodity investment. High volatility in commodity prices has also led
to contentious political pronouncements on the role of financial investment in commodity markets and to calls for further regulation. Here, we shed new light on these issues produced with market data and support from CME Group.
Study Objectives We look at the performance and risk
characteristics of long-only commodity portfolios and of long-short commodity strategies of the kind implemented by hedge fund managers with a focus on commodities, such as commodity trading advisors (CTAs) and commodity pool operators (CPOs). In particular, we investigate the conditional
volatility of these commodity futures investments and their conditional correlations with traditional assets. Indeed, the strategic decision to include commodity futures in a well-diversified portfolio does not solely depend on the risk premium of
commodity futures viewed as an asset class but is also driven by a desire for risk diversification and thus depends on how the returns of commodity investments correlate with the rest of the investor’s portfolio over time. We thus analyse the conditional volatility of long-
only and long-short commodity portfolios and the conditional correlations of their returns with those of traditional assets in periods of high volatility in traditional asset markets. To the extent that previous studies have focused on long-only investing, this study is a relevant addition to the literature on modern commodity futures investment. We have also examined the possible impact that long-short trades may have had on the volatility of commodity prices and on their conditional correlation with traditional assets. This topic is of interest given the recent debate amongst politicians and policy makers surrounding the financialisation of commodity futures markets. The 2009 Staff Report by the US Senate Permanent Subcommittee on Investigations argues that commodity index
Recent market gyrations ... led to an
increasing recognition of the relevance of long-short dynamic strategies
traders were disruptive forces, driving prices away from fundamentals. If established, this would support calls for an increase in transparency, position limits and margins to curb excessive speculation and, it is hoped, volatility. The claim that the financialisation of commodity markets is responsible for the observed volatility in commodity prices has been the subject of an intense academic debate – the overwhelming conclusion of which has been that it is not possible to empirically link investments in commodity futures and commodity futures prices. However, the debate has so far focused mainly on the potentially destabilising role of long-only, as opposed to long-short, investors. We fill this gap by studying the potentially
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