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Relative carry is determined by the shape of the futures curves and yield
measures of commodity equities.
Relative carry is a profitable signal for both long-only or long-short strategies on commodity equities and futures with return-to-risk ratios above 1.
Results are robust to various specifications and underlying indices. Commodity equities provide both diversification and inflation hedging benefits. A strategy that hedges the excess equity exposure has even better diversification characteristics.
Ruy M. RibeiroAC
(44-20) 7779-2217 [email protected] J.P. Morgan Securities Ltd.
The certifying analyst is indicated by an AC. See page 13 for analyst certification and important legal and regulatory disclosures. www.morganmarkets.com
220 200 180 160 140 120 100 Dec-02 Dec-04 Dec-06 Dec-08 Dec-10 RV Strategy Long-Short
Source: J.P. Morgan, S&P, Bloomberg. MSCI World is proxied by the same futures basket. we use for hedging.
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S&P Global Natural Resources ER Hedged Commodity Equity MSCI World Net TR
the strategy that invests in a hedged commodity equity index. The hedged index is the combination of a long position in the selected commodity equity index and a short position in a basket of equity index futures that is designed to track the MSCI World Index (only developed markets, to be clear). By hedging the excess equity exposure, we achieve four goals as we create a commodity equity index that has: correlation to equities that is similar to the one commodity futures indices have (Chart 4) ; a higher correlation to commodity spot prices than other commodity equity indices (Chart 5); and a better risk-adjusted performance and lower volatility (Chart 3 and 6).
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The sizing of the short position is based on the betas of both commodity equities and commodity futures to this global futures basket. In the base-case strategy, the objective is to construct a hedged commodity equity index that has the same low sensitivity to global equities that a commodities futures index has at each point in time. So if the sensitivity of commodity futures to global equities is cf,e and sensitivity of commodity equities to global equities is ce,e, then we go short ce,e - cf,e of global equities, as this is excess beta to global equities (see diagram in Chart 7). We considered caps and floors to minimize the effect of estimation error. Other methods were considered with similar qualitative results. As the risk profile of commodity futures and equities changes over time, we estimate betas on a daily basis using a rolling window. We tested a range from 21 to 126 days with similar performance. Our reported numbers are based on exponentially-weighted betas, where 50% of the weight is given to the past month data. Using dynamic estimates of beta has been particularly important in the recent past as we have seen a significant change in the correlation and beta between commodity prices and equity prices, possibly a structural change, in the view of some market participants. For the sake of completeness, we present strategy results for versions with and without global equity hedging. By hedging part of the equity risk, the two investment options become more comparable, as the hedged equity index provides exposure to the commodity-driven performance of the commodity equity index. An alternative is to compare the investment in commodity equities to an investment in a basket of commodity futures and global equities. In this case, investors compare an investment in commodity equities to an allocation to global equities with a commodity overlay. Hedging increases the correlation to commodity spot prices, but that does not imply that correlation is now 1. In fact, we would not expect that to happen as commodity equities provide an alternative exposure to the commodity story. Commodity equity returns reflect changes in current spot prices but should also anticipate changes in expected future spot prices as they affect the present value of all future profits. Moreover, commodity firms may (efficiently or not) implement hedging strategies. Commodity firms can also be jointly exposed to multiple commodity sectors as costs of running the business are related to commodity prices (particularly energy costs). Another interesting characteristic is that hedged commodity equities are less volatile that commodity futures.
CE-E
Excessive beta is hedged out
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Excessive beta
Commodity future returns are related to spot performance but also affected by the shape of the curve. If the curve is in contango, i.e., positively sloped, the negative roll cost (more precisely, the negative slide) will make actual returns lower than spot returns. If the curve is in backwardation, returns are higher than spot returns. As most indices pick only one point of the curve, they do not necessarily benefit from bullish steepenings (increase in longer-dated prices without increase in short-dated ones)
S&P GSCI F3 12.0% 26.3% 0.46 -0.13 4.50 -66.8% -22.8% 10.1% 7.35 9.5% 1.12 9.4% 6.97
S&P GSCI ER 1.5% 28.8% 0.05 -0.05 4.16 -71.6% -29.1% 0.0% 0.00 0.1% 0.01 0.0% 0.00
Performance
In this section, we show that our base-case relative value strategy has outperformed in a consistent manner both a static allocation into commodities futures and a static allocation into commodity equities. Most results are based on a sample since 2002 due to index data availability, but we later extend some of the results to longer data with other indices. Our sample ends in November 2011. Allocations are rebalanced on the first business day of every month based on information available on the last business day of the previous month. The strategy has posted higher excess returns with lower volatility than our commodity benchmark for the purpose of this paper, the S&P GSCI Index (Chart 1, second page and Table 1). Both average drawdown and maximum drawdown
3 More detailed methodology and additional robustness tests not reported here are available upon request. In the base-case strategy, we considered a model where we hedge the excess equity exposure. The equity signal uses 12-month forward I/B/E/S earnings yields and 10-year swap rates. Additionally, we split the position between equities and futures, whenever the relative value measure is within -2.5% and 2.5% to avoid excessive trading (robust to changes).
are lower for the strategy. The rolling 12-month return is almost always higher than the one delivered by commodities futures exposure (Chart 8). Risk-adjusted performance is robust to the choice of the asset pricing model used in the analysis. In a regression on the S&P GSCI, the slope coefficient (Jensens alpha) is statistically significant. It remains significant even if we include MSCI World as a pricing factor or only use equities as a pricing factor (Table 1). The performance of alpha-based long-short strategies is also strong (Chart 9). In these versions, we also go short commodity futures indices and/or equities indices based on
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220 200 180 160 140 120 100 Dec-02 Dec-04 Dec-06 Dec-08 Dec-10 RV Strategy Long-Short
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rolling beta estimates. For example, every end of the month, we estimate the rolling beta of the relative value strategy to the commodity futures benchmark and go short that amount of the commodity future index (S&P GSCI) for the following month. By doing so, we hedge the exposure to commodity futures, making this strategy uncorrelated to this benchmark. We apply a risk-control mechanism to make sure the risk capital allocated to the strategy is stable over time. The correlation of the long strategy to commodities is high as expected (Chart 10) and the correlation to equities tracks the variation followed by standard commodity indices (Chart 11). In the full sample, the correlation to the S&P GSCI index was 0.78. Note that correlation to equities has been a lot higher since the onset of the financial crisis.
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Agriculture Futures
Agriculture Equities
The base-case strategy provides a diversified exposure to both commodity futures and commodity equities. Charts 12.A to 12.C show the composition of the portfolio for each of the commodity sectors. The composition has never been concentrated in only futures or equities. On average, the allocation has been roughly even into futures and equities. While we ignore transaction costs in the reported results, we also evaluated the profitability of cost-adjusted versions. On the conservative side, an overall cost of 50-70bps per year would be sufficient to cover all the necessary expenses/ trading costs to run the strategy, assuming the appropriate infrastructure.
No equity hedging
The relative value strategy has performed well even without the use of the equity hedging feature. The objective of equity hedging is to make the two investment alternatives more comparable as we choose between assets that have a similar correlation to equities3. Table 2 shows that performance statistics remain attractive without hedging. For the sake of completeness, we also analyze another version where we choose between commodity equities and a basket of commodity futures and equities, a solution that also makes the two alternatives more comparable. This version (not reported here) is suitable to investors that prefer no short positions and are also happy with equity exposure (due to their positive risk premia).
with other commodity-based strategies to deliver even higher risk-adjusted returns. We considered a few long-short strategies. The first version goes long the base-case strategy and short S&P GSCI. The advantage of this version is that it is easier to implement. Due to the difference in the risk profiles of the long and short positions, we match the volatility of these two positions. We also apply a risk control mechanism that caps the volatility at 5%. (Chart 9)
3 While we do not report results here due to its technical nature, we also considered other choices of hedging ratios. In the base case strategy, we match the beta to global equities, which seems a reasonable assumption. We also considered a case where beta to equities is set to zero and that betas are estimated in two-step regressions or multiple regressions. 7
Alpha strategies
Long-short versions of this strategy provide strong and uncorrelated performance. This is an interesting solution for investors that are not interested in commodity beta. This long-short strategy also has low correlation to other longshort strategies in commodities. Thus, it can be combined
The second version goes long the base-case strategy and short the underlyings that were not selected by the basecase strategy, using the same weighting scheme for both long and short positions. Even though this is a better measure of the alpha of the strategy, this version is more costly to replicate as it may require going short cash equities (or impossible in the presence of short selling constraints). The alpha of these two versions is statistically significant. Table 3 shows that the intercept of the regression of the long-short strategy returns on the S&P GSCI excess return indices is statistically significant at a 5% significance level. The correlation to other alpha strategies in commodities is low, thus providing diversified source of returns (Table 3). The correlation to a commodity slide long-short strategy is 0.29 (see Ribeiro, R.M., Profiting from slide in commodity curves, 2008). The Sharpe ratio of a 50-50 risk-weight strategy since 2002 around 2.70, which is higher than the Sharpe ratio of the individual strategies. The correlation to a momentum strategy is only 0.09, providing once again good diversification (see Ribeiro, R.M. et all, Momentum in Commodities, 2006 and Ribeiro, R.M. et all, Optimizing Commodities Momentum, 2008).
Performance statistics
RV Strategy Long ER Avg Exc Return Std Deviation Sharpe Ratio Skewness Kurtosis Max Drawdown Ave Drawdown Alpha (GSCI) t-stat Alpha (MSCI) t-stat Alpha (Both) t-stat
Source: J.P. Morgan, S&P, Bloomberg.
RV Strategy Long ER (Using dividend yield) 21.4% 20.2% 1.06 -0.01 5.03 -35.0% -7.0% 19.1% 4.55 16.6% 2.67 16.5% 4.18
19.8% 19.5% 1.02 -0.05 5.23 -35.3% -6.7% 17.7% 4.13 15.2% 2.58 15.1% 3.80
Using other hedging positions The base-case strategy uses a MSCI World-weighted basket of rolling futures strategies. Results are robust to other hedging strategies, as performance is nearly the same if we use MSCI World AC and S&P500 for the short position. Using other commodity equity indices and longer samples There are other sector equity indices that provide access to commodity exposure. Our conclusion is that outperformance has been independent of the choice of the underlying commodity equities. For example, performance remained very similar when using the CRBEQ indices (Table 5). Using the CRB sample since Dec 1999, we find that the long strategy had a Sharpe ratio of 0.90 vs 0.11 for the S&P GSCI Index. Performance is not as strong when using other less specific indices, but results with other equity indices are still better than following a static commodity allocation. We also tested the strategy using sector/industry groups of standard indices, such as the S&P 500. As an advantage, some of these indices are available in ETF format. We also tested the model with broader US equity indices. We considered the S&P 500 Select Industry indices, which are designed to measure the performance narrow GICS subindustries: Oil Production and Exploration (SPSIOPTR Index) and Metals and Mining (SPSIMMTR Index). Data are available since December 1999. Results are not comparable to the base case strategy as we trade only energy and metals. In this analysis, we assume that both precious metals and agriculture weights are allocated into commodity futures.
RV Strategy Long CRB ER 20.7% 20.9% 0.99 -0.26 4.01 -40.1% -8.7% 18.5% 4.45 15.8% 2.51 15.8% 4.11
19.8% 19.5% 1.02 -0.05 5.23 -35.3% -6.7% 17.7% 4.13 15.2% 2.58 15.1% 3.80
As narrow indices do not have long history, we also use broder indices that correspond to the top level of the GICS industry classification and include only S&P 500 stocks. The indices are: Energy (SPTRENRS Index) and Materials (SPTRMATR Index). We also considered an Agriculture subindex (S5AGRI Index) as a proxy for total returns in the Agriculture sector. We should note that these indices are broad and may include companies that do not belong to the targeted commodity sectors. In this analysis, we assumed that precious metals weights are allocated into commodity futures. A version of the strategy that uses the S&P Global Natural Resources indice and, before their base date, the S&P 500 sub-indices has delivered a Sharpe ratio of 0.77 vs 0.08 for the S&P GSCI since Dec 1994. Note that some of the information used in this model is not available in 1994, so, in this version, information is added as it becomes available. We find that the relative value strategy has paid off since the mid 80s. As discussed previously, we lack long historical data on commodity equity indices. In order to evaluate the robustness of this concept with longer data, we tested a simpler version that trades one commodity futures index (S&P GSCI WTI Crude Oil) and one broad sector index (Datastream US Energy). In this version, we hedge the equity exposure using the Datastream US equity index. This simpler relative value strategy had a Sharpe ratio of 0.68, while a long only positiong in the Crude Oil index delivered only 0.36, which is economically significant since we are trading only one commodity.
Single commodity sectors The relative value strategy also works well in the single commodity sector level (Table 6). We revisit the long-short strategy discussed in an earlier section, but now apply it to energy, metals or agriculture each at a time. The short position is the S&P GSCI index of the respective sector. We also apply a risk control mechanism to limit the volatility of the long-short position. We also considered a version that matches the volatility of the long and short positions and risk profiles could be potentially quite different. Charts 13.A to 13.C show that the strategy adds value for every single sector.
Other robustness tests For the sake of brevity, we omit some of the robustness tests that were performed. One of these tests was to consider multiple definitions of commodity slope/slide. The base-case strategy uses the slope of the contract selected by the S&P GSCI F3 index (or the chosen index), which is the obvious choice of slope as it measures the slide of that contract. Nevertheless, we also tested the strategy with other definitions of slope (front slope and one-year slope) with similar qualitative results. For a similar discussion, see Ribeiro, R.M. Profiting from slide in commodity markets, 2009. In the base case strategy, we use a two-month average of current and past slope. We have also tested the sensitivity of other minor parameters of the model. For example, we looked at the effect of changing the beta estimation window in equity hedging or of using an exponentially-weighted beta. In all cases, we found the model to be quite robust. We also considered a neutral zone for the relative value measure, so whenever the measure is not clearly negative or positive given a chosen threshold, we select a balanced position into both futures and equities.
Inflation hedging
The relative value strategy adds alpha to a long-only commodity investment, while maintaining a similar risk profile. In particular, we find that the relative-value long-only strategy remains an efficient inflation hedging asset as the rolling correlation to future inflation is of the same magnitude (Chart 14). The average correlation to inflation is 0.55, while S&P GSCI has a correlation of 0.66 since 2002.
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Diversification benefits
We also find that the diversification benefits are improved with this relative value strategy. Table 8 confirms that the relative value strategy has the same correlation to global equities that S&P GSCI has, but significantly lower volatility. From the point of view of an US investor, the correlation to other asset classes, such as equities, government bonds, high grade and high yield is also similar, while performance has been superior. Hence, a tactical allocation to commodity future indices seems to be better than a passive one. We have made similar arguments in previous papers such as Ribeiro, R, Economic and Price Signals for Commodity Allocation, 2009.
Conclusion
Investors are increasingly obtaining strategic exposure to commodities, mostly to gain diversification, to hedge against event risks from supply disruption, and to be positioned for the eventual exhaustion of natural resources. But the frequent negative yield (roll) on commodity futures is preventing many investors from holding as much as they would like. We offer here a dynamic investment rule, that switches commodity exposure from futures to commodity equities stocks issued by commodity producers when the yield on these equities exceeds the roll on futures. The paper shows that this rule significantly increases the return from holding commodities without having much impact on their role in hedging against commodity price shocks and inflation.
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