A Relative-Value Commodities Index
Passive indexing strategies have become well established over the past 30 years. These strategies are designed to match a well-defined market segment with a low-cost (and possibly tax-efficient) approach to investing. There is considerable evidence that passive indexing strategies are especially pertinent for large institutional investors, due to their low cost and low fees, as well as their transparency. Passive funds typically have lower turnover than active funds.
Long-only commodities indexes have done well over extended periods of time. Figure 7 shows the FTSE 500 alongside a popular commodities index—the S&P GSCI. The S&P GSCI is an index of long-only investments in the most actively traded commodities and is a popular benchmark for many institutional investors.
There are several evident observations. First, the overall price patterns of the S&P GSCI and FTSE 500 are roughly similar. The S&P GSCI outperformed the FTSE 500 and similar equity indexes over the entire 1999-2011 time period in terms of returns, with associated higher volatility and drawdown values. Second, the S&P GSCI experienced severe losses during the crash period of 2008-09, partially due to the sharp correction in oil and other energy-based commodities.
Figure 8 shows that spot prices of commodities rose along with equities in early 2009 until early April 2011. However, the iShares S&P GSCI Commodity-Indexed Trust (NYSE Arca: GSG), which tracks the well-known commodities index, achieved much lower performance during the same period. The underperformance is largely due to the presence of contango in many commodities markets, especially energy products, over the selected time periods. The commodities prices in contango lowered returns since the index is long-only.
To address the problems with long-only commodities investments—primarily large drawdowns and losses due to contango—we developed a relative-value commodities index using the following four subtactics: long momentum; short momentum; long futures curve; and short futures curve.6 Each of these tactics is based on a relative ranking of the commodities under study.7 Briefly, the four tactics are designed to capture alpha embedded in commodities markets, while carefully balancing the long and short positions in the portfolio—in order to minimize drawdowns and produce positive returns with excellent diversification characteristics (as compared with traditional assets). Recall that managed futures investments can be designed as an overlay strategy—providing additive performance to standard assets.
Figure 9 depicts the performance of the relative long- and short-momentum tactics. Note that the relative long-momentum tactic outperforms the relative short-momentum tactic over most of the entire span. However, during crash periods—2001-02 and 2008-09—the short-momentum tactic did much better than its long-only counterpart. The two tactics combine to provide a more stable return pattern.
A similar characteristic occurs with the long and short futures curve tactics (Figure 10). Here, the long futures tactic has the better long-term return as compared with the short-futures tactic, but does suffer from sharp drawdowns. Again, the combined long-short tactic has superior return/risk characteristics.
Figure 11 depicts the performance of the long-short relative-value commodities strategy, along with the market-neutral version during 1999-2011. The relative value approach applies regimes for determining the tilting of long and short positions. Figure 12 shows the results of the relative value index. In addition, we provide the empirical results of a regime detection system for U.S. equities [Guidolin et al. 2007; and Mulvey et al. 2011].
Since we can gain exposure to commodities via the futures markets, we can enhance the returns of traditional assets. In this example, we couple commodities with a regime-identifying equity model [Mulvey et al. 2011]. The overall performance is excellent. In particular, we focus on the ratio of return to risks wherein risk is measured by the Ulcer Index8—downside risks relative to drawdown. The combination of commodities and a careful, regime-based equity strategy is clearly attractive and has low correlation with the FTSE 500.9