Oil: Backwardation to the future

Oil: Backwardation to the future Wisdomtree

Oil futures curves have been in backwardation – when the closer futures contract can be sold for a higher price than it costs to buy a futures contract with a further expiry date, resulting in a profit for the investor – for most of the past year, driven by perceived tightness in short-term supply1. This has provided investors with ‘roll yield’ on top of the gains made from spot price movements in oil.

While we believe that the oil market is balanced at present, there is supply tightness in specific areas – especially in heavier crudes – and this could be enough to ensure that the oil futures curve remains mostly in backwardation going forward. Here’s a closer look at current oil market supply and demand dynamics.

Oil curve backwardation

Recent curve backwardation has largely been engineered by the Organisation of Petroleum Exporting Countries (OPEC). Since January 2017, the oil cartel has restricted the supply of oil by assigning its members and partners a quota for the amount of oil that they produce. Although the cartel has historically had a poor history of complying with quotas, this time it has done exceptionally well. Part of the reason for this, is that up until June 2018, each country was allocated an individual quota (rather than a group-wide limit) and this helped to restrict oil supply.

Another reason OPEC has done well in complying with quotas is because of unintended production disruptions. Recently, Venezuela has experienced an economic implosion, and this has impacted oil production significantly. Supply disruptions in Libya and Nigeria have also contributed to OPEC supply volatility.

Can backwardation last?

In June 2018, OPEC abandoned individual country quotas, so the level of quota compliance that we have seen over the past year may not last if the organisation reverts to its old ways. This could explain why the very front of the Brent futures curve went back into contango – when it costs more to buy the new futures contract than the amount received from selling the old futures contract – in July and August. Indeed, Saudi Arabia – the largest OPEC nation – has clearly expanded production since the end of the country-quota system, as have other countries.

After going back to an all-backwardated curve, the short end of the curve is now back in contango, a move underpinned by fears of over supply from increasing rig count in the US, as well as delays in the full implementation of sanctions on Iran. Despite those recent developments, we do not expect them to significantly impact long term supply. While the front end of the curve will remain prone to shifts, we do not see it to durably get back to a mostly contangoed curves.

Figure 1: Year-on-year difference in OPEC oil production

Source: Bloomberg, WisdomTree, data available as of close 05 October 2018.
Historical performance is not an indication of future performance and any investments may go down in value.

Tightness concentrated in heavy crudes

In relation to supply disruption, supply of the ‘heavier’ crudes is most at risk, in our view. Venezuela, Iran and Canada produce ‘heavy’ (low API gravity), ‘sour’ (high sulphur) crudes and these countries experienced the bulk of supply disruption this year.

Most of the world’s growth in crude oil supply is currently from US tight oil, which is ‘light’ (high API gravity) and ‘sweet’ (low sulphur). So, even though global oil supply is close to balance at the headline level, growth in oil production is uneven, with declines in supply of heavy crudes, and gains in supply of light crudes2.

Moreover, while US tight oil is seeing supply growth, there are limitations to this growth. Infrastructure needs to grow in lock-step with growth in oil production, and infrastructure limitations could slow the pace at which US shale can help satisfy global oil needs.

Demand remains strong for now

Looking at forecasts from the International Energy Agency (IEA), demand for oil looks set to remain healthy, with the IEA expecting oil demand to grow by 1.4 mb/d in 2018, and 1.5 mb/d in 2019 (following 1.5 mb/d growth in 2017). Over the medium term, the dearth of capital investment in oil production is likely to lead to tightness if demand continues to remain robust.

Oil futures likely to remain in backwardation

While we believe that the market is in balance at present, there is supply tightness in specific areas and this could be enough to ensure that the futures curve remains mostly in backwardation.

We don’t believe that a new wave of supply is forthcoming as a lack of investment in oil exploration and production should keep supply contained, and it may only take another supply shock to Libya or to Canada to cast doubts on supply. We also think that demand will remain robust, assuming today’s bullish demand expectations are not unfounded.

Source

1 For a full description of backwardation, contango, roll yields, spot return, total return, excess return and collateral yield please see Costs and Performance Tab on our ETPedia page.

2 Energy Information Administration, WisdomTree, data available as of 04 October 2019.

This material is prepared by WisdomTree and its affiliates and is not intended to be relied upon as a forecast, research or investment advice, and is not a recommendation, offer or solicitation to buy or sell any securities or to adopt any investment strategy. The opinions expressed are as of the date of production and may change as subsequent conditions vary. The information and opinions contained in this material are derived from proprietary and non-proprietary sources. As such, no warranty of accuracy or reliability is given and no responsibility arising in any other way for errors and omissions (including responsibility to any person by reason of negligence) is accepted by WisdomTree, nor any affiliate, nor any of their officers, employees or agents. Reliance upon information in this material is at the sole discretion of the reader. Past performance is not a reliable indicator of future performance.

Riskhantering på råvarumarknaden

Riskhantering på råvarumarknaden

Råvaror tenderar att, i alla fall till viss del, okorrelerade med aktiemarknaden. I denna artikel diskuterar vi fördelarna med att ha exponering mot råvaror och tittar närmare på Riskhantering på råvarumarknaden.

I den här artikeln kommer vi att täcka de två primära metoderna för att komma åt råvaruprisrörelserna: terminsbaserad och aktiebaserad. Medan båda har fördelar och nackdelar har vi tittat närmare på en strategi som löser de flesta nackdelarna från dessa metoder.

Terminsbaserad

Breda råvarukorgar, inklusive strategier som använder futureskontrakt, är allmänt accepterade för att ge den starkaste korrelationen att fånga prisrörelser. Ett terminsavtal är helt enkelt ett avtal om att köpa en viss mängd av en råvara i en viss månad till ett visst pris. Därför kommer värdet av att inneha detta kontrakt att röra sig när det underliggande råvarupriset rör sig, vilket ger en högt korrelerad tillgång till det priset.

En av frågorna med terminsavtal är emellertid att de löper ut och vanligtvis har ett positivt tidsvärde. Råvarupriserna tenderade generellt att följa inflationen. Vi borde då förvänta oss att råvarupriserna generellt stiger över tiden. Om jag köper ett terminsavtal som ger mig rätten att köpa en mängd varor i framtiden skulle jag troligen betala ett premie för att ”låsa in” dagens pris. Ju längre ut kontraktet är daterat, desto högre premie skulle jag vanligtvis betala för kontraktet. Detta begrepp är känt som ”contango”.

En råvarufond, som använder futures, har inget intresse av att utnyttja kontraktet och ta emot leveransen av råvaran själv. När tiden går och kontraktet närmar sig förfall minskar tidvärdet (premie) och fonden kommer så småningom att sälja positionen. Ett nytt kontrakt måste då köpas och, om det är i contango, kommer det att kosta mer att ersätta ett kortfattat kontrakt med ett längre daterat kontrakt. Denna process för att ständigt förnya positionerna förstör naturligt prestanda, vilket visas nedan:

Spotpriser vs terminsbaserad avkastning

Källa: FactSet, 2018. Tidigare resultat är ingen garanti för framtida resultat, vilket kommer att variera. Det är inte möjligt att investera direkt i ett index.

Ett annat problem med terminsbaserade strategier är att majoriteten är strukturerad som partnerskap, som utfärdar K-1-inkomster. Som ett resultat måste partnerskapet förbereda ett schema K-1 för att rapportera varje partners andel av dessa skatteposter. Flera fonder har utvecklats för att ta itu med K-1 problematiken, men de stöter på en annan typ av skattefråga, där K-1 radering mekanism kan konvertera kapital till högt beskattade vanlig inkomst.

Slutligen har vissa segment av råvaror små djup på marknaden. Till exempel, energiterminer har tre gånger så många kontrakt som finns, jämfört med jordbrukskontrakt.1 I ett försök att förhindra prismanipulation har Commodity Futures Trading Commission targit fram särskilda bestämmelser kring hur mycket av ett kontrakt en enskild handlare kan äga. Eftersom en futuresbaserad fond växer i storlek blir dess förmåga att behålla en betydande position i ett mindre segment av marknaden begränsad. Med energi är en av de största terminsmarknaden för råvaror, är det inte förvånande att energi tenderar att vara en av de största innehav av terminsbaserade strategier.

Aktiebaserad metod

Låt oss nu diskutera den aktiebaserade metoden. Fonder med strategier för råvaror fördelar sina tillgångar till aktier från företag som är starkt knutna till råvaror. Argumentet är att framtida företagstillväxt starkt påverkas av råvarupriset.

Medan aktiebaserade strategier löser de terminsbaserade problemen med contango, K-1 och marknadsdjup införs en annan typ av risk: ökad korrelation med aktiemarknaderna och därefter ytterligare volatilitet. Morningstar Natural Resources Fund Category har till exempel uppvisat en högre standardavvik än Bloomberg Commodity Spot Index och både inhemska och internationella aktier (representerade av S & P 500 och MSCI EAFE Index) över en fem-, 10- och 15- årsbasis. Detta visar tydligt att volatiliteten hänförlig till aktiemarknadsinflytande förenar volatiliteten hänförlig till spotprisrörelser.

Standardavvikelse

[TABLE=223]

Källa: Morningstar, per den 12/31/17. Tidigare resultat är ingen garanti för framtida resultat, vilket kommer att variera. Det är inte möjligt att investera direkt i ett index.

Hitta gemensam mark

Aktiemarknaderna uppvisar en ”push and pull” på naturresursaktier som dämpar fallet för diversifiering av aktier och sammansatt volatilitet utöver spotprisrörelser. Med tanke på denna dynamik är det meningsfullt att identifiera en lösning som hanterar aktiemarknadens inflytande. Att ge en kort exponering mot både en bred inhemsk aktieexponering (S & P 500) och internationell exponering (MSCI EAFE) skulle ge avkastning mitt emot indexet. Till exempel, om S & P 500 ger en 2% avkastning, skulle den korta exponeringen förlora 2%, och om S & P 500 förlorar 3%, skulle den korta exponeringen få 3%.

Att kombinera en aktiemarknad med korta exponeringar med naturresurserna skulle ”dra” när marknaden ”pushar” och ”push” när marknaden ”drar”. Nästa steg är att bestämma hur mycket effekt en marknad har på naturresursaktier.

Det ultimata målet att testa en optimal marknadslägeexponering är att uppnå liknande volatilitet, upp/ner-fångst och beta till Bloomberg Commodity Spot Index som det futuresbaserade breda råvaruindexet. Genom att göra det skulle det minska motgångarna i likviditetsstrategin, samtidigt som man undanröjer nackdelarna med framtidsbaseradestrategier, eftersom terminsavtal inte utnyttjas.

För att testa detta koncept bör du överväga en period när Morningstar Natural Resources Fund-kategori uppvisade sin starkaste korrelation med aktier, vilket gör det mest utsatt för korrekt tillgång till spotprispåverkan. Såsom ses under 1 års efterföljande period ökade korrelationen och var nära 1 (den starkaste korrelationen) från mitten av 2009 till slutet av 2011. Med tanke på detta är rullande ettårs korrelation bör vi börja i mitten av 2008 och titta igenom slutet av 2010 för att undersöka den höga korrelationsperioden.

Natural Resources Fund-kategorin rullande ettårskorrellation

Tidigare resultat är ingen garanti för framtida resultat, vilket kommer att variera. Det är inte möjligt att investera direkt i ett index.

Den söta punkten på maximal sänkning av standardavvikelsen, samtidigt som den totala avkastningen behålls under den analyserade perioden, verkar vara en säkring på 7 procent till inhemska aktier (S & P 500) och 7 procent till internationella aktier (MSCI EAFE) med en minskning av lång position till 95%. Nedtagningen av Morningstar Natural Resources Fund-kategorin (med dessa säkringar implementerade) till Bloomberg Commodity Spot Index kommer in i 98%, med en upptagning på 83%. Detta är nästan identiskt med Morningstar Broad Basket Commodity Funds kategori (82% upptagning och 98% nedtagning). Betat för Bloomberg Commodity Spot Index var dessutom .931, i linje med beta av .935 för kategorin Broad Basket.

[TABLE=224]

Tidigare resultat är ingen garanti för framtida resultat, vilket kommer att variera. Det är inte möjligt att investera direkt i ett index.

Efter att de relevanta mätvärdena har gått tillbaka i närheten av vad en investerare skulle få tillgång till med terminer, är den totala avkastningen över tiden, som ses nedan, inte bara fortsatt stark, men ser bättre ut att spåra Bloomberg Commodity Spot Index än obehandlade naturresurser:

Tillväxt av 100 dollar

Tidigare resultat är ingen garanti för framtida resultat, vilket kommer att variera. Det är inte möjligt att investera direkt i ett index.

 

Börshandlade fonder som drar nytta av Volatilitet

Börshandlade fonder som drar nytta av Volatilitet

Volatilitet flyttar aktiemarknaderna på lika tillförlitligt sätt som pris eller volym. Denna får börsen att expandera och kontrakterar över tiden i takt med girighet och rädsla. Perioder med hög volatilitet återspeglar högriskmiljöer med hög belöning, där perfekt timing kan skapa imponerande vinster medan det blir fel kan utlösa allvarliga förluster. Många marknadsaktörer undviker prissättning helt under stressiga perioder, istället lägger satsningar på volatilitetsriktningen genom VIX-futures eller specialfonder som reagerar på dessa kontrakt. Medan man utnyttjar dessa instrument krävs avancerade färdigheter, är belöningen kan vara värt ansträngningen, särskilt när volatilitetstrenderna är starka, högre eller lägre. Låt oss titta på Börshandlade fonder som drar nytta av Volatilitet.

Ger en realtidsbild

CBOE Market Volatility Index (VIX) som skapades 1993 ger en realtidsbild av girighet och rädsla, liksom förväntningar på volatilitet under de kommande 30 börssessionerna.

VIX utgör grunden för framtida prissättning, liksom strategier som tidtagare på marknaden kan använda till tidsposter och utgångar i volatilitetsbaserade aktiefonder. Sedan Finanskrisen 2008 har dessa komplexa instrument blivit väldigt populära för både hedge och momentum.

Köp och försäljning av dessa värdepapper har genererat en ledande effekt på VIX-indikatorn och VIX-futures de senaste åren tack vare sin enorma volym. Du kan se detta hända när medel bryts ut, bryta ner och vända sig före den underliggande indikatorn. Denna effekt är mest utbredd i mycket volatila marknadsförhållanden.

Handelsinstrument

Medan VIX-futures erbjuder den renaste exponeringen för volatilitetens upp- och nedgångar, attraherar volatilitetsfonderna mycket mer volym eftersom de är lättillgängliga genom en egen depå. I stället för börshandlade fonder (ETF) är många av dessa instrument Equity Traded Products (ETP) som använder komplexa beräkningar som lägger flera månader av VIX-futures till korta och medellångsiktiga förväntningar.

”Volatilitetsfonder”

  • S&P 500 VIX Short-Term Futures ETN (VXX)
  • S&P 500 VIX Mid-Term Futures ETN (VXZ))
  • VIX Short-Term Futures (VIXY)
  • VIX Short-Term ETN (VIIX)

    Inverterade eller hävstångsfonder med fokus på volatilitet
  • Daily Inverse VIX Short-term ETN (XIV)
  • Short VIX Short-Term Futures ETF Y)
  • Ultra VIX Short-Term Futures ETF (UVXY)
  • Daily 2x VIX Short-Term ETN (TVIX)
  • Daily Inverse VIX Medium-Term ETN (ZIV)

Realtidsprissättning av fonder sänks genom contango, vilket speglar tidsmässiga variationer mellan terminsavtal och spotpriser. Dessa beräkningar kan pressa vinsten på volatila marknader, vilket gör att säkerheten kraftigt underpresterar den underliggande indikatorn. Som ett resultat fungerar de bäst i kortsiktiga strategier som utnyttjar aggressiva exittekniker, långsiktiga strategier och hedgar, och i kombination med VIX-futures.

VIX-analys

Volatilitetsfondsstrategier kräver en tvåstegsstrategi som granskar VIX samt prisåtgärder på den riktade fonden. En förståelse för VIX teknisk analys kan mildra contangons vinstdämpande effekt genom att identifiera nivåer och vändpunkter där medel kommer att förlora trendmomentet. Det fungerar eftersom längre daterade terminskontrakt som används för att beräkna prissättningen är mindre känsliga för kortvarig VIX-rörelse, vilket har större effekt när trendmomentet ökar.

VIX-diagrammet genererar vertikala spikar som speglar perioder med hög stress, inducerad av ekonomiska, politiska eller miljömässiga katalysatorer. Det är bäst att titta på absoluta nivåer när man försöker tolka dessa skarpa mönster, letar efter omkastningar runt stora runda nummer, som 20, 30 eller 40 och nära tidigare toppar. Också uppmärksamma interaktioner mellan indikatorn och 50- och 200-dagars EMA, med dessa nivåer som fungerar som stöd eller motstånd.

Håll VIX på dina skärmar när du överväger poster i volatilitetsfonder. Jämför trenden med prisåtgärder på populära indexkontrakt, inklusive SP-500 och Nasdaq-100. Konvergens- och divergensrelationerna mellan dessa instrument genererar observationer som hjälper till med marknadsundersökning och riskhantering:

Olika scenarion

Stigande VIX + stigande SP-500 och Nasdaq-100 index futures = bearish divergens som förutspår krympande risk aptit och hög risk för en omvänd omvändning.

Stigande VIX + fallande SP-500 och Nasdaq-100 index futures = bearish konvergens som ökar oddsen för en downside trenddag.

Fallande VIX + fallande SP-500 och Nasdaq-100 index futures = bullish divergens som förutspår ökad riskappetit och hög potential för uppåtriktad reversering.

Fallande VIX + stigande SP-500 och Nasdaq-100 index futures = bullish konvergens som ökar odds för en upside trend dag.

Divergerande åtgärder mellan SP-500 och Nasdaq-100 index futures sänker förutsägbar tillförlitlighet, vilket ofta ger whipsaws, förvirring och rangbundna förhållanden.

Mät volatilitetstrender med lång- och kortvariga VIX-diagram, letar efter sympatiska fondspel. Stigande VIX tenderar att öka korrelationen mellan aktieindex och underliggande komponenter, vilket gör exponeringen på långsidan mer attraktiv. Fallande VIX reverserar denna ekvation, som stöder korta poster som kräver vinst medan VIX återgår till mer långsiktiga medelvärden.

Sammanfattning

Volatilitetsfonder erbjuder exponering för höga ”girighet och rädsla” nivåer samtidigt som man undviker förutsägelser om prisriktningen. Komplex fondkonstruktion gör dem bäst lämpade för kortsiktiga handelsstrategier i flyktiga förhållanden och långsiktiga strategier på kortsidan i godartade och tysta förhållanden, inklusive tjurmarknadsmiljöer.

How to mitigate the cost of contango

How to mitigate the cost of contango

Asset Allocation Research How to mitigate the cost of contango

Highlights

  • An investor in commodities using futures contracts is not only exposed to the price of the raw material but also to the cost of holding a futures contract and rolling it from one contract to another.
  • To mitigate the cost of rolling (contango), investors need to add exposure to futures contracts with a longer shelf life where volatility is lower but expected return is also less.
  • Since 2002, a portfolio of both short and long maturity contracts outperformed short maturity only contracts by 6.5% per year, enhancing the Sharpe ratio to 0.26.
The mechanism of contango and backwardation continues to intrigue. While contango is known to reduce an investment’s overall return, questions remain as to whether it is possible to avoid it. In this note, we will focus on oil and particularly Brent, looking at the different elements investors should be aware of before considering investing in commodities as well as how to mitigate the negative impact of contango on the performance of a portfolio.

The futures curve

A futures curve is a series of prices of futures contracts that expire at different points in time (as illustrated below). Because each commodity follows its own fundamentals, the shape of the futures curve tends to vary from one commodity to another. Oil futures curves for example, tend to reflect market expectations on the future direction of oil prices. The previous chart shows how the futures curve of Brent has moved since last year. The entire curve shifted upward with futures contracts at the short end of the curve benefitting most compared to contracts at the longer end of the curve. The chart also shows that liquidity, measured by the traded volume on each futures contract, is higher at the short end of the futures curve where financial services and speculators tend to be concentrated. Smaller volumes at the longer end of the curve are usually commercial positions taken by consumers or producers of oil using the futures market as a hedge.

The impact of fundamentals

Because the futures curve is made of futures contracts that expire at different points in time, a change in the fundamentals will have variable impact on the price of each contract. An event such as the OPEC/non-OPEC agreement has the potential to keep the longer end of the future curve flat for a while as the market expects producers to continue controlling supply going forward. However, the current price support at the short end of the curve may vanish if the deal was to fail, deepening the contango at the short end of the curve. The above chart shows that the correlation between the level of US oil inventories and oil prices at the short end of the curve is higher than the correlation with the longer end of the curve. Futures contracts at the short end are more sensitive to the change in supply, demand and inventories than the longer end. With US shale oil production on the rise, contango at the short end may deepen in the near term. As a result, futures contracts with short-term maturity tend to be more volatile than contracts at the longer end as illustrated in the chart below. On the other hand, any gain or loss will be higher with short maturity contracts than long maturity contracts.

Long backwardation short contango

Because of the liquidity issue mentioned earlier, it is difficult for speculative investors to get exposure to the longer end of the curve. Most investors are therefore exposed to the short end of the curve where roll cost and volatility are the highest. In this section, we look at whether it is possible to build a portfolio that will mitigate the negative impacts of contango on return by ensuring exposure to the best part of the curve. For this purpose, we have created the following three portfolios: – Our benchmark is 50% in Brent futures contracts with an average maturity of one month and 50% in contracts that have an average maturity of two years. – Two long only portfolios using the change in oil prices over the past month and the shape of the future curves at the end of the past month as trading signal. One portfolio invests in either the short end (Brent 1mth) or the longer end (Brent 2Yr) while the other portfolio will overweight the maturity highlighted by the signal and underweight the other maturity at the same time. The performance chart shows that all the portfolios including the benchmark outperformed an exposure to the short maturity contract as holding Brent 1Mth since 2002 would have provided a return of 1.5% per year. Both long only portfolios outperformed the benchmark by 1.8% per year on average and the long only portfolio that alternates between Brent 1Mth and 2Yr outperformed Brent 2Yr by 0.2% per year. In addition, the summary table highlights that both portfolios have a lower level of volatility than the benchmark and Brent 1Mth, allowing for an increase of the Sharpe ratio by 39% on average compared to the benchmark. A maximum recovery time of more than 8 years for all the portfolios and constituents indicate that they have yet to recover to their previous peak in June 2008. With OPEC taking back control of their production level and US shale oil now profitable with a price around US$50/bbl., a recovery back above US$100/bbl. is simply unrealistic for the time being. Looking at the performance since the beginning of 2016 when oil prices started to recover from a 13-year low, the long only portfolio with either Brent 1Mth or 2Yr is posting the highest Sharpe ratio at 0.69, followed by the long only portfolio combining both (0.66), Brent 1Mth (0.63), the 50/50 benchmark (0.57) and Brent 2Yr (0.50). When using futures contracts to get exposure to commodities, an investor needs to be aware of the composition of the return the investor will get, as a gain in the commodity price does not necessarily translate in a gain in the investment’s overall return. When the futures curve is in contango, the cost of rolling from one contract to the other is deducted from the gain in price and will reduce the end return. While investors generally prefer an exposure to the short end of the curve due to liquidity, adding an allocation to futures contracts at the longer end can reduce the negative impact of contango and improve returns. Since 2002, the portfolio combining both maturities outperformed the short maturity exposure by 6.5% per year, enhancing the Sharpe ratio from -0.01 to 0.26. The strategy also allows for more diversification.

Important Information

This communication has been issued and approved for the purpose of section 21 of the Financial Services and Markets Act 2000 by ETF Securities (UK) Limited (“ETFS UK”) which is authorised and regulated by the United Kingdom Financial Conduct Authority (the “FCA”). The information contained in this communication is for your general information only and is neither an offer for sale nor a solicitation of an offer to buy securities. This communication should not be used as the basis for any investment decision. Historical performance is not an indication of future performance and any investments may go down in value. This document is not, and under no circumstances is to be construed as, an advertisement or any other step in furtherance of a public offering of shares or securities in the United States or any province or territory thereof. Neither this document nor any copy hereof should be taken, transmitted or distributed (directly or indirectly) into the United States. This communication may contain independent market commentary prepared by ETFS UK based on publicly available information. Although ETFS UK endeavours to ensure the accuracy of the content in this communication, ETFS UK does not warrant or guarantee its accuracy or correctness. Any third party data providers used to source the information in this communication make no warranties or representation of any kind relating to such data. Where ETFS UK has expressed its own opinions related to product or market activity, these views may change. Neither ETFS UK, nor any affiliate, nor any of their respective officers, directors, partners, or employees accepts any liability whatsoever for any direct or consequential loss arising from any use of this publication or its contents. ETFS UK is required by the FCA to clarify that it is not acting for you in any way in relation to the investment or investment activity to which this communication relates. In particular, ETFS UK will not provide any investment services to you and or advise you on the merits of, or make any recommendation to you in relation to, the terms of any transaction.  No representative of ETFS UK is authorised to behave in any way which would lead you to believe otherwise. ETFS UK is not, therefore, responsible for providing you with the protections afforded to its clients and you should seek your own independent legal, investment and tax or other advice as you see fit.

How to make the best of commodities: the contrarian model

How to make the best of commodities: the contrarian model

ETF Securities Asset Allocation Research –  How to make the best of commodities: the contrarian model

Summary

  • Commodities used in a passive asset allocation strategy have been underperforming other asset classes for a fifth consecutive year in 2015.
  • An exposure to commodities in a balanced or growth portfolio of equities and bonds can still benefit investors with a long-term investment horizon.
  • An active strategy such as the contrarian model could have provided an effective protection against the commodities rout over the past 5 years.

Download the complete report (.pdf)

Commodities in a passive strategy

While commodities have performed poorly over the past few years, by including commodities in a portfolio of bonds and equities (for example using the Bloomberg Commodity Index) could have improved returns over the past 25 years.

Commodities have historically had a low correlation with other asset classes. Driven by commodity-specific factors, they tend to provide higher return for the same level of risk when added in a standard portfolio of stocks and bonds.

Using a portfolio of stocks and bonds as the benchmark, we run a passive portfolio model under three different styles: cautious, balanced and growth. The portfolios follow a strategic asset allocation model that rebalances every quarter to the original weighting over a period of 25 years.

(Click to enlarge)

*Weights at the bottom refer to the weight of bonds. Portfolio 1 has 10% in commodities.
Portfolio 2 has 10% in commodities ex-energy. MSCI World is the proxy for equities, Barclays
Capital Bond Composite-Global Index for bonds, Bloomberg Commodity Index 3 Month
Forward for commodities and Bloomberg ExEnergy Subindex 3 Month Forward for
commodities ex-energy. Source: ETF Securities, Bloomberg

Our analysis shows that commodities don’t add any value in a cautious portfolio where the allocation into bonds is the highest (80%). While balanced and growth portfolios are by nature more volatile than the cautious portfolios, both substantially outperformed cautious portfolios by 20% and 23%, respectively, on average. In the balanced and growth portfolios, allocating 10% into commodities enhances the portfolio Sharpe ratio regardless of whether the commodity basket includes energy or not.

Role of commodities in a portfolio

The below chart illustrates how commodities in a passive asset allocation model have played a crucial role in enhancing the Sharpe ratio of a standard portfolio of equities and bonds between 1991 and 2005. During these years, commodities posted strong returns for a level of risk similar or lower than stocks. Between 2006 and 2010, the optimal weight of commodities fell to 1.5% and then dropped to nearly zero over the past 5 years to December 2015.

(Click to enlarge)

* MSCI World is the proxy for equities, Barclays Capital Bond Composite-Global Index for bonds and Bloomberg Commodity Index 3 Month Forward for commodities. The risk free rates are equal to 1.39% (1991-1995), 0.92% (1996-2000), 0.90% (2001-2005), 0.65% (2006- 2010) and 0.08% (2011-2015) (5 years average of US 10 years rate). Source: ETF Securities, Bloomberg

Our analysis shows that applying a strategic asset allocation model to commodities works well during periods of strong performance. The years between 2001 and 2005 for instance were ‘the golden years’ for commodities. However, during bear market periods such as that over the past five years, actively managed strategies would have provided better returns than the passive Bloomberg Commodity Index 3 Month Forward.

Examples of active strategies

An active strategy or a tactical asset allocation typically involves getting exposure to riskier securities in order to increase the potential return of a portfolio. An actively managed portfolio generally rebalances the weights based on various types of signals and could involve the introduction of short selling and leverage.

A short exposure to commodities enables investors to benefit from negative spot return and a futures curve in contango. An effective strategy is then to play the shape of the futures curve. In this strategy, investors are short commodities in contango and long commodities in backwardation. Implementing this strategy on futures contracts at the short end of the curve increases the portfolio return significantly but also its volatility compared to traditional commodity indices.

Another interesting strategy is the calendar spread which consists in getting exposure to futures contracts further out on the curve while selling near-term contracts at the same time. Short maturity futures contracts are more sensitive to price movement and roll costs than futures contracts that expire in 6 months plus. Commodity indices exposed to contracts with longer lifespan tend to enhance investors risk/return profile.

The contrarian portfolio

The contrarian model is a hybrid long only asset allocation strategy based on the contrarian reading of four indicators: inventories, positioning, roll yield and price momentum. We derived five portfolios from the model: one based on the contrarian reading of each indicator and one based on the contrarian reading of all four indicators combined. In the latter, each commodity is scored based on how each of their respective four indicators has recently evolved. The selected commodities are then equally weighted in the portfolio with the selection reassessed and rebalanced every quarter.

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*BCOMF3= Bloomberg Commodity Index 3 Month Forward, Global stocks = MSCI World and Global bonds = Barclays Capital Bond Composite-Global Index. Source: ETF Securities, Bloomberg

Over the past 15 years, the best performing contrarian portfolio is the portfolio based on the contrarian reading of the roll yield. Exposed to commodities in contango between its front and third month contracts, the portfolio has outperformed other contrarian portfolios by 32.6% on average. Its annual return over the past 15 years is on average 5 times higher than the annual return of existing commodity indices and global stocks and 4 times higher than the annual return on global bonds.

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*CMCI = UBS Bloomberg CMCI Composite, DBLCI = Deutsche Bank Liquid Commodities Index. Source: ETF Securities, Bloomberg

Over the past 5 years, while enhanced or optimised commodity indices are falling 12% per year on average, the momentum and roll yield portfolios have been flat. Global stocks rose 4.4% and global bonds increased by 2.4% per year over the same period.

(Click to enlarge)

*Risk-free rates equal to 1.94% (2001-2015) and 0.38% (2011-2015). Source: ETF Securities, Bloomberg

Over both periods, the volatility of contrarian portfolios has been close to the volatility of existing commodity indices and global stocks. Combined with strong returns, the average Sharpe ratio of the contrarian portfolios is 0.78 over 15 years, 11.3% higher than the Sharpe ratio of global bonds.

All the charts and performance data in this note are based on the price of commodity front month futures contracts excluding fees. Introducing a fixed execution fee of US$1 per day per contract does not have any significant impact on each portfolio annualised return over 5 or 15 years.

To conclude, there are great benefits of taking a contrarian perspective when reading certain indicators such as roll yield. During commodity bull periods, between 2001 and 2010, each contrarian portfolio outperformed other asset class indices by far including commodity. Like existing indices, the model works best during periods of strong momentum for commodities. However, the overall model also provides an effective protection against commodity market downturns such as that over the last 5 year rout.

For more information contact

ETF Securities Research team
ETF Securities (UK) Limited
T +44 (0) 207 448 4336
E info@etfsecurities.com

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