Swedroe: Virtues Of A Long/Short Strategy

Much of the academic research on commodities has focused on the impact of including an allocation to long-only commodity strategies in a portfolio. Joelle Miffre and Adrian Fernandez-Perez add to the literature with a paper on the performance and volatility of long-only and long-short commodity portfolios, as well as their conditional correlation with equities (represented by the S&P 500 Index) as well as bonds (represented by the Barclays Capital U.S. Aggregate Bond Index).

The study—“The Case for Long-Short Commodity Investing,” which appears in the Summer 2015 issue of The Journal of Alternative Investments—covered two periods and 27 commodities. The first period began on January 5, 1979, and the second period began on October 2, 1992. Both ended on March 25, 2011.

Study Results

Following is a summary of the authors’ findings:

• Long/short portfolios based on momentum, term structure and hedging pressure offer better performance than their long-only counterparts. For example, during the period 1992 through 2011, 96 percent of the long/short commodity portfolios studied generated Sharpe ratios that exceeded that of the S&P-GSCI.
• The conditional volatility of long-short commodity portfolios was less than that of long-only portfolios.
• In periods of turmoil in equity and fixed-income markets, as contagion spreads across markets, the volatility of long/short commodity portfolios rose less than that of long-only commodity portfolios.
• The conditional correlation of the S&P 500 with long/short commodity portfolios (at 0.00, on average) were lower than those measured relative to long-only commodity indexes (at 0.15), suggesting that the risk diversification benefits of commodity futures are stronger within long/short portfolios.
• In periods of high volatility in equity markets, the conditional correlation between the S&P 500 and long-short commodity portfolios based on the positions of hedgers and speculators decreased. This is good news for equity investors, because it is precisely when the volatility of equity markets is high (for example, following the demise of Lehman Bros.) that the benefits of diversification are most appreciated. Relative to long-only strategies, the diversification benefit of long/short portfolios is greater for stocks than for bonds. In other words, bond investors should be indifferent between long-only and long/short allocations to commodities.

A Superior Approach

The authors concluded: “Altogether, the results highlight the superiority of long/short strategies.” I would add that the authors measured futures returns by assuming that investors hold the nearest contract up to one month before maturity, and then rolled their position to the second-nearest contract.

Research has shown that managing the choice of roll dates, based on the cost of rolling for different maturities, has improved results. And avoiding forced trading on roll dates has also been found to have added value.

Given the concerns (and supporting evidence) that the “financialization” of commodities has likely increased the costs—and thus reduced the benefits—of long-only commodity strategies, the findings presented in this study provide investors with an alternative worth considering.

I’ll also note that the AQR Multi-Style Premium Fund includes long/short commodity positions (accounting for about 10 percent of the positions). In the interest of full disclosure, my firm, Buckingham, recommends AQR funds in constructing client portfolios, and I have a significant allocation to the fund.

Larry Swedroe is the director of research for The BAM Alliance, a community of more than 140 independent registered investment advisors throughout the country.