Do strategy-based commodity indexes introduced in recent years offer value to investors? In the February 2012 version of their paper entitled “Strategic and Tactical Roles of Enhanced Commodity Indices”, Georgios Rallis, Joelle Miffre and Ana-Maria Fuertes compare the returns and risks of enhanced long-only commodity indexes that exploit signals based on the time-to-maturity, momentum and term structure to those of two traditional commodity indexes: the Standard & Poor’s Goldman Sachs Commodity Index, and the Dow Jones-UBS Commodity Index. Using daily data for commodity futures contracts spanning October 1988 through November 2008, they find that:
- Maturity enhancements use the same commodity weights as traditional indexes but roll monthly to contracts targeting an average maturity (expiration) of 3, 6, 9 or 12 months instead of rolling to the nearest expiration. For these enhancements:
- Gross annualized outperformance relative to traditional indexes ranges from 3.0% to 6.2%, increasing systematically as target maturity increases.
- Average returns (volatilities) of most constituent commodities tend to increase (decrease) as target maturity increases.
- However, average returns and volatilities of precious metals vary little with target maturity.
- Lower liquidity of distant contracts does not fully account for all of the maturity enhancement.
- Momentum enhancements adjust the commodity weights of traditional indexes up or down each month, depending on prior-month returns relative to the median for all commodities. These enhancements outperform the two traditional indexes by a gross 1.3% and 1.5% annually, with comparable volatility.
- Term structure enhancements adjust commodity weights of traditional indexes up or down each month, depending on prior-month roll returns relative to the median for all commodities. These enhancements outperform the two traditional indexes by a gross 2.4% and 2.0% annually, with comparable volatility.
- Momentum and term structure combination enhancements adjust commodity weights of traditional indexes up or down each month based on double sorts of prior-month relative returns and relative roll returns (in either order). These combined enhancements outperform the two traditional indexes range from a gross 1.5% to 2.9% , with comparable volatility.
- In general, the maturity enhancements are more attractive than the momentum and term structure enhancements, and the 12-month maturity target offers the best performance.
- The authors conjecture, but do not demonstrate, that the outperformance of all the enhancements survive trading frictions because: commodity futures trading costs are low (less than 0.033%); the number of positions held is small (no more than 30 commodities); and, the assets traded are reasonably liquid.
- The enhanced indexes are just as effective as the traditional indexes for strategic diversification of equity and fixed income portfolios and for hedging against inflation shocks.
Tables in the paper present other performance metrics for enhanced commodity indexes.
In summary, evidence from backtesting indicates that commodity indexes enhanced by momentum, roll return and (especially) maturity may be better ways to invest in commodities than traditional commodity indexes.
Cautions regarding findings include:
- As noted, all return calculations ignore trading frictions.
- Testing multiple rules on the same dataset introduces data snooping bias, such that the best result likely overstates reasonable out-of-sample expectations.
- The sample does not include data since the recent financial crisis, which may represent a regime change in commodity futures behavior.
- The study does not examine the evolution of the outperformance of enhancements over time. There may be some degree of market adaptation.
The authors identify the following enhanced commodity indexes as open to investment as of the date of the paper: Bache Commodity Index, Barclays Commodity Index, Credit Suisse Commodity Benchmark Index, Deutsche Bank Liquid Commodity Index, Diapason Commodity Index, DCI BNP Paribas Enhanced Index, JPMorgan Commodity Index, Merrill Lynch Commodity Index, MorningStar Commodity Index, UBS Bloomberg Constant Maturity Commodity Index.
