Absolute-Price Patterns And Variance From Annual Average Prices
There are two important considerations when trading commodities for beta optimization (alpha), especially those commodities most affected by fundamental seasonal patterns. Most commonly utilized by investors (especially those exclusively seeking alpha) is the concept that a commodity or market can create relatively predictable seasonal patterns of absolute-low and absolute-high prices. Less commonly utilized, but of immense importance to asset allocators and/or investors seeking long-term beta exposure, is the concept of variance from annual average prices.
For an asset allocator who wants to initiate (or increase) beta exposure in a given commodity, the concept of variance from annual average prices is important. Investors seeking to achieve long-term exposure to a given sector (beta) are perhaps less interested in entering at the absolute-price low than they might be in simply maximizing the efficiency of their exposure to that particular commodity or sector. Seasonal variance from the annual average is therefore an important factor when initiating or adding to a long-term beta exposure position.
On the other hand, an alpha investor is probably more interested in picking an absolute-price top or bottom. That investor's interest will lie therefore in the seasonal patterns supporting absolute-pricing patterns rather than in the divergence from the average that is of critical interest to a beta investor.
Sugar, the agricultural commodity that has both the lowest correlation and the lowest regression value in the above-referenced study, offers a good example of how investors might use both seasonal absolute-pricing patterns and seasonal divergence from average annual pricing patterns to optimize beta and/or achieve alpha in their portfolios.
Due to the fundamental factors of weather and harvest cycles, as illustrated in Figure 4,9 the price of sugar as represented by front-month futures—in both absolute terms and in terms of its relative negative divergence from the annual average prices—often reaches its maximum low point between April and June. This coincides with peak harvest time in Brazil, the world's largest exporter of sugar and sugar cane.
Investors aware of this fundamental characteristic of the sugar markets can use this historical seasonal pattern in three ways. First, investors building their own basket of commodities-based beta exposure can add sugar at these times. Second, investors already holding a basket of commodities that contains sugar, but perhaps in an amount or weighting that is not sufficient for their beta diversification needs, can add even more sugar to their portfolio at these times. Third, investors seeking alpha, i.e., those trading to increase the absolute returns of their portfolio component to achieve higher performance using sugar, might also use these opportunities to buy or overweight sugar.