Investors are becoming well versed in using alternative risk premia to efficiently measure, isolate, and gain access to alternative sources of return through rigorous, liquid, and transparent rules-based indices across asset classes. Risk premia that are economically intuitive, persistent over time, and executed in highly liquid markets are likely to offer the most benefit to market participants. In the commodities market, concepts such as carry have a strong economic rationale, while the underlying commodities themselves exhibit low correlation to traditional asset classes and are traded in liquid derivatives markets. The prevalence of non-profit-seeking participants in the commodities market adds to their attractiveness.
Exploits the relationship between a commodity’s return and its recent relative performance history. It is based on the premise that a price trend once established is likely to continue—long (overweight) commodities showing an upward price trend and short (underweight) securities showing a downward trend.
Goes long (overweight) or short (underweight) individual commodities based on the slope of the futures curve. If the futures curve is upward sloping, it is said to be in contango, and if it is downward sloping, it is said to be in backwardation. Commodities in backwardation (contango) should generate a positive (negative) roll yield, and therefore a positive (negative) excess return when market conditions remain unchanged.
Gives exposure to the roll yield of an individual commodity futures contract. This could involve optimizing contract positioning on the futures curve to minimize roll cost based on roll yield in a long-only strategy or taking a short position in a nearby contract and a long position in a deferred contract, often referred to as a calendar spread in an absolute return strategy.
Exhibit 4 illustrates the correlation and performance among the headline S&P GSCI and the first two absolute return commodities risk premia indices launched by S&P DJI in February 2021. The S&P GSCI Curve 3 Month performed well during the COVID-19 pandemic risk-off environment, with the majority of commodity futures curves in contango. In contrast, the S&P GSCI Momentum underperformed the headline S&P GSCI over a one-, three-, and five-year period.
Source: S&P Dow Jones Indices LLC. Data from Feb. 31, 2016, to Feb. 29, 2021. Index performance based on total return in USD. Correlation based on past five-year monthly returns. Past performance is no guarantee of future results. Table is provided for illustrative purposes and reflects hypothetical historical performance. Please see the Performance Disclosure at the end of this document for more information regarding the inherent limitations associated with back-tested performance.
The underperformance of momentum strategies has been evident across asset classes for some time. In the case of commodities, there is little evidence to suggest that this underperformance is a function of market saturation. It would appear that the underlying commodities have simply not displayed strong or persistent price trends (Babbedge & Kerson, 2019). Despite that commodities momentum has been mixed over the past decade, long-term history suggests that momentum remains a systematically harvestable risk premium.
Incorporating the fundamental dynamics of the commodities market presents a challenge and an opportunity for risk premia strategies. Supply and demand levels, and specifically inventory levels, determine spot commodities prices. Having a grasp of commodities market fundamentals is important in the design and execution of risk premia strategies and may assist in the mitigation of potential losses (Hill, 2019).
The broad role of commodities in asset allocation may also be advanced by alternative risk premia. For some market participants, the use of a passive multi-strategy risk premia commodities allocation in a traditionally balanced portfolio may be an attractive alternative to passive long-only commodities exposure (Sakkas & Tessaromatis, 2018). For market participants unable or unwilling to employ absolute return strategies, long-only commodities exposure that is tilted to reflect risk premia such as carry, curve, or momentum can be an alternative.
