LONG-SHORT COMMODITY INVESTING
Key Survey Results
(i) Commodity futures are relevant as an asset class but it is necessary to use long/short strategies to reap the commodity risk premium. (ii) The diversification benefits of the long-only approach to commodity futures investing have taken a hit in the post-Lehman period but long/ short strategies continue to be excellent diversifiers. (iii) The diversification benefits of long-only investing are unequivocally reduced in times of financial stress (correlations with equities and bonds rise), while long-short commodity portfolios are found to provide a partial hedge against extreme risks in equity markets (correlations fall when the volatility of equities rises) and to better withstand turbulence in fixed income markets. (iv) There is little to no evidence that the increased participation of long/short investors on commodity futures markets has caused an increase in the volatility of their portfolios or in the correlations of these portfolios with traditional assets.
also low for the long-short portfolios. Statistical tests of differences between these correlations suggest that, other things being equal, bond investors are better off from a risk management perspective holding the S&P-GSCI than commodity portfolios based on past performance or on past roll-
benefits of diversification are most appreciated. In contrast, the conditional correlations between long-only commodity indices and equity indices rise with the volatility of the S&P500, suggesting that the risk reduction that comes from diversification prevails less when needed most. The four weeks that followed the demise of Lehman Brothers provide an acid test of these relationships. The S&P500 lost 8.18% a week, the long-only commodity portfolios retreated sharply, whereas the long-short commodity strategies studied here earned between -1.72% and 2.02% a week. These results suggest that, unlike long-only commodity portfolios, long-short commodity strategies can serve as partial hedge against extreme equity risk. In periods of high volatility in fixed income markets,
the conditional correlations between the Barclays Capital US Aggregate Bond Index and the long-short commodity portfolios based on the positions of commercial and non- commercial traders are found to remain constant, whereas the conditional correlations measured relative to long-only commodity portfolios are found to rise sharply. This suggests that, other things being equal, long-short commodity portfolios based on the positions of hedgers and speculators
can serve as better diversifiers than long-only commodity portfolios in periods of extreme risk in fixed income markets. We can confirm the relevance of commodity futures investment
These results suggest that, unlike long-only commodity portfolios, long-short commodity strategies can serve as partial hedge against extreme equity risk
returns. The evidence is less clear-cut for strategies based on the positions of commercial and non-commercial traders.
Correlations Under Stress We then focus on the behaviour
of conditional correlations between traditional asset classes and commodity investments when the former are under stress. In 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 commercial and non-commercial traders are found to decrease. This is good news to equity investors as it is precisely when the volatility of equity markets is high that the
42 March 2012
and presents reasons as to why long-short strategies should prevail over long-only investing: they provide superior risk- adjusted performance as reflected by higher Sharpe ratios; have lower conditional volatility than the leading long-only benchmark index; and they offer more effective diversification qualities for equity portfolios, especially in the recent period. Furthermore, long- short commodity portfolios based on the positions of commercial and non- commercial traders are found to have partial hedging characteristics providing
protection against extreme-risk in the equity markets and to offer stable diversification properties in times of turbulence on the fixed income markets.
Increased Financialisation of Commodity Futures The second purpose of our study is to present evidence on the
financialisation of commodity futures markets and investigate the possible impact that long-short trades may have had on the volatility of commodity prices and on their conditional correlation with traditional assets. Two points are worth noting. First, the dramatic changes in the
long open interests of non-commercial traders seem to parallel the dramatic ups and downs of the S&P-GSCI over the period 1992-2011. This gives credibility to the claim that changes in the long open interests of investors could have increased the volatility of the S&P-GSCI. Second, both the long and short positions of investors have
risen sharply over the period 1992-2011, suggesting an increase in the financialisation of commodity futures markets. We investigate whether the increased role of financial investors has been a disruptive force in commodity futures markets. This
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