How do commodity futures behave in the post-financialization era, with commodities easily accessible via exchange-traded instruments and futures? In their September 2014 paper entitled “Factor Structure in Commodity Futures Return and Volatility”, Peter Christoffersen, Asger Lunde and Kasper Olesen analyze commodity return and volatility dynamics since financialization (after deregulation of commodity markets in the early 2000s). They consider 15 contract series comprised of the three most heavily traded of each of energy (light crude, natural gas, heating oil), metals (gold, silver, copper), grains (soybeans, corn, wheat), softs (sugar, coffee, cotton) and meats (live cattle, lean hogs, feeder cattle). They focus on: whether factors might explain commodity returns and volatilities, and integration of commodity markets with the equity market. In assessing continuous positions, they roll from an expiring commodity contract to the subsequent contract when daily volume of the latter exceeds that of the former. Using daily returns derived from over 750 million commodity futures contract trades for the selected 15 series and for SPDR S&P 500 (SPY) during January 2004 through December 2013, they find that:
- Regarding daily returns:
- Commodity futures exhibit widely varying average daily returns, ranging from -0.02% for natural gas to 0.05% for heating oil.
- There is evidence of a factor structure in daily commodity futures returns. The first four principal components explain 30%, 15%, 10% and 7% (a total of 62%) of the differences in returns across the 15 commodity futures series. Explanatory power concentrates in oil, metals and grains.
- Regarding daily return volatilities:
- Commodity futures exhibit widely varying daily return volatilities, ranging from 1.23% for live cattle to 3.96% for natural gas. Volatilities exhibit extremely high persistence.
- Evidence for a factor structure in daily volatility is stronger than for returns, with stock market volatility clearly a factor.
- Volatilities do not trend upward over the sample period.
- Regarding mutual diversification:
- Commodity futures are mutually diversifying. The average pairwise daily return correlation across all commodities is just 0.25, ranging from 0.12 for lean hogs to 0.34 for light crude.
- There is little evidence of a trend in the level of mutual diversification over the sample period.
- Regarding diversification of U.S. stocks:
- Commodity futures diversification of SPY varies considerably, with daily return correlations ranging from 0.06 for lean hogs to 0.45 for copper.
- Commodity futures exhibit high betas with the stock market during 2008-2010, but betas then revert to pre-crisis levels near zero. There does not appear to be a permanent loss of ability to diversify stocks.
In summary, evidence over the last decade indicates that commodity futures markets again diversify the equity market based on returns, but their volatilities are substantially integrated with stock market volatility.
Cautions regarding findings include:
- The paper does not address strategic allocation based on findings.
- The 2008-2010 loss of diversification power of commodity futures for stocks based on returns may recur in crisis conditions.
