The Tactical and Strategic Value of Commodity Futures

1. Q Group Spring Seminar 03-05 April 2005 Key Largo The Tactical and Strategic Value of Commodity Futures 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 S&P 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% S&P 500 50% GSCI GSCI Total Return S&P 500 Intermediate Treasury 3-month T-Bill Inflation Note: GSCI inception date is December 1969. During this time period, the S&P 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 return=15.3% beating the S&P 500 return of 11.6% • 1992-2004, compound return of 7% while S&P 500 was 10.4%

9. Commodity Futures: Beware of Indexes • DJ-AIG – Traded since 1998 • But performance backfilled to 1991. • 1991-1998, compound annual return=4.1% beating the GSCI which only had 0.5%

10. Commodity Futures: Beware of Indexes • CRB – Traded since 1986 • But performance backfilled to 1982.

11. 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.

17. 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.

18. 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

19. Figure 5Excess and Spot ReturnsDecember 1982 to May 2004

20. 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.

21. Figure 6Excess Returns and Roll ReturnsDecember 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:

23. Commodity Futures: Inflation Hedge? • Inflation • Unexpected Inflation • Expected Inflation • Change in Inflation

24. Figure 8GSCI Excess Return and Unexpected InflationAnnual Observations, 1969 to 2003

25. Table 4Commodity Excess Return And Change in Annual InflationAnnual Observations, 1982 to 2003

26. Commodity Futures: Inflation Hedge? • Variation across commodities • Link to roll return

27. Figure 9Unexpected Inflation Betas and Roll ReturnsDecember 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

28. Commodity Futures: What is the Risk? Risk Factors • Market • Term • Default • SML • HML • Change in FX

29. Table 5Unconditional Commodity Futures BetasMonthly Observations, December 1982 to May 2004 Note: *, **, *** significant at the 10%, 5% and 1% levels.

30. Commodity Futures: Diversification Return • Need to rebalance portfolio • What is the return due to rebalancing?

31. Table 6The mechanics of the diversification return

32. Figure 10Commodity Futures Index Diversification Returns

33. Commodity Futures: Strategic Allocation • Mean variance analysis • What do you collateralize with?

34. Figure 11Strategic Asset AllocationDecember 1969 to May 2004 S&P 500 Collateralized Commodity Futures 2 Intermediate Bond Collateralized Commodity Futures GSCI (Cash Collateralized Commodity Futures) 1 S&P 500 60% S&P 500 40% Intermediate Treasury Intermediate Treasury

36. Figure 11Strategic Asset AllocationDecember 1969 to May 2004 S&P 500 Collateralized Commodity Futures 4 Intermediate Bond Collateralized Commodity Futures 3 2 GSCI (Cash Collateralized Commodity Futures) 1 S&P 500 60% S&P 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 PersistenceDecember 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

40. 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.

41. Figure 14GSCI Momentum ReturnsDecember 1982 to May 2004

42. 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.

43. Table 8Momentum strategies based on: GSCI, bonds, cash, and equityDecember 1969- May 2004

44. 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.

45. 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.

46. Commodity Futures: Tactical Allocation • We now consider a variation of the strategy that uses the sign of the previous 12-month’s 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.

47. 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.

48. 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.

49. 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.