Thursday, January 21, 2016

Long/short portfolios - the smarter commodity trade

Commodities are not like other asset classes. They will be affected by different factors from stocks and bonds. This is one of their key attributes. Commodities will offer unique diversification, but their uniqueness is also what will harm investors who think that they can just hold long-only exposure in order to receive consistent gains. Commodities cannot all be bundled together, energy markets are different from metals or agriculture.

The commodity cycle is different from the business cycle and the cycle for each commodity is usually significantly different. The cycle for in-the-ground commodities is different form those that are mined or below-the-ground. The commodity cycle will generally last longer than a business cycle. Right now we are in the down portion of the cycle even though the overall global business is still positive albeit losing momentum. Commodity markets as accessed through futures will be subject to hedging pressure and short-term storage issues which are very different from equity and bond markets.

This uniqueness means is that a combination of long and short positions across commodities, treating them uniquely, may be a more effective approach to investing than holding a long-only basket. Joelle Miffre from the EDHEC business school looks at all of the research in this area and shows that using simple strategies that combine long and short exposure to commodities will do better on a risk adjusted basis than holding basket, "Long-short commodity investing: A review of the Literature".

This review work mainly focuses on the research that has tested the theory of storage and hedging pressure. Looking at forming long/short combinations based on backwardation and contango will generate good  returns to risk across many different time periods. The same conclusion applies when testing a hedging pressure story. Investors are paid to take on the risk from short hedgers. This suggests that a long-short combination is an effective way to invest in commodities. The review also includes analysis of trend or momentum long/short portfolios and the combination of backwardation with momentum. Combinations work well for adding value. There have also been work on testing risk and skew portfolios which show that  finding long/short combination is an effective strategy.

While the downturn in the commodity cycle is a problem for long-only investing, there are other ways to invest in commodities that provide good risk adjusted returns and diversification without taking pure directional risk. This does not mean that the long/short strategies have always been winners, but it does say that long-only or avoidance strategies may be a portfolio view that is too extreme. 

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