Commodity Futures Investing: Complex and Unique




About the Author

Wesley R. Gray, Ph.D.

After serving as a Captain in the United States Marine Corps, Dr. Gray received a PhD, and was a finance professor at Drexel University. Dr. Gray’s interest in entrepreneurship and behavioral finance led him to found Alpha Architect. Dr. Gray has published three books: EMBEDDED: A Marine Corps Adviser Inside the Iraqi Army, QUANTITATIVE VALUE: A Practitioner’s Guide to Automating Intelligent Investment and Eliminating Behavioral Errors, and DIY FINANCIAL ADVISOR: A Simple Solution to Build and Protect Your Wealth. His numerous published works has been highlighted on CBNC, CNN, NPR, Motley Fool, WSJ Market Watch, CFA Institute, Institutional Investor, and CBS News. Dr. Gray earned an MBA and a PhD in finance from the University of Chicago and graduated magna cum laude with a BS from The Wharton School of the University of Pennsylvania.


  • trr

    I found this article very illuminating, thank you! However, I don’t see the question of commodities via futures versus via equities settled here. The interesting question is not whether the equities route replicates the futures route. (I don’t see GMO, in the paper you cite, claiming that.) The interesting question is which is better.

    You argue that commodities futures admit a strategy based on momentum and term structure. Well, commodities equities admit a strategy based on momentum and value (as well as the tax efficiency, simplicity, transparency, and liquidity that you mention, and also an equity premium).

    You argue that commodities futures provide diversification whereas commodities equities add more equities risk. But GMO argue that commodities equities also provide diversification, especially on long time frames. Not all equities risk is the same. As for short-time frames, I suppose one might look for crisis alpha or crisis protection, but I don’t believe either (long) commodities futures or commodities equities provide that.

  • Thanks for your comments.

    Clarified the language wrt GMO.

    We discuss the term structure aspect but don’t really discuss momentum in any detail. Based on our work, term structure is a different beast than value or momentum equity premiums. Love to see if you know of research suggesting otherwise.

    Commodity equities are equities. And I think the evidence is clear that comm_eq equity beta risk is the big muscle movement in those assets movements. Commodity futures are futures and their risk premias are driven by spot risk and carry risk as outlined in this article, which seem to be different beasts than equities.

    All that said, if one is specifically interested in inflation hedging (point on the GMO piece), and looking at taxes, transparency, etc., there is a good discussion to be had. However, if you buy commodity equity to get your inflation hedge, but they just stack more equity risk in your portfolio, you might be better off getting your inflation hedge via futures and also getting the genuine portfolio diversification benefits. I could see it going either way depending on circumstance.

  • trr

    Thank you.

    I don’t mean to suggest a relationship between term structure and value or momentum, just that commodities equities can also be refined by strategies.

    You write “equity beta risk is the big muscle movement” (in commodities equities) which suggests they do not offer the genuine portfolio diversification you see in futures. But GMO claim low (or even negative) correlation between commodities equities and the rest of the equity market on a 3-10 year time-scale. That sounds like genuine portfolio diversification to me.

  • Got it.

    I’m attaching some basic stats on the following portfolios from Ken French’s website (1927 to 2015, total returns, gross of fees): French Oil, French Mining, Value-weight CRSP, and SP500.
    1) French oil is the oil sector according to their 30 industry codes
    2) French mining is the mining sector using the same 30 industry codes. Details are here: http://mba.tuck.dartmouth.edu/pages/faculty/ken.french/Data_Library/det_30_ind_port.html
    3) VW CRSP is essentially all stocks with market-cap weighting
    4) SP 500 is essentially = VW CRSP

    Some summary stats:
    https://uploads.disquscdn.com/images/afc422ba6a7a1cda3cf8bb037c93de91c16e9be89ff1471d48561f0d2dc9758f.png
    –high vol, high drawdown 65-75% correlation

    Some 4 factor analysis:
    https://uploads.disquscdn.com/images/0833e7caf35bb0a247e744ffe057c176a2c250620d5b5df20910859cbfc6d0de.png
    –vast majority of returns are attributed to beta exposure

    Some 5 yr rolling CAGRs:
    https://uploads.disquscdn.com/images/f106b0f08276b165a7650e51b50d196a50907b965d4713da99890ba088da5030.png
    –highly correlated — especially during the first half of the sample
    Some 5yr rolling maxDD:
    https://uploads.disquscdn.com/images/9a282822897ef2443f4f482caec734aeba6b83d16a94b58c2f58c19b48302bc2.png
    –highly correlated across the board

    My conclusion from this analysis is GMO needs to go back to the drawing board and conduct some out of sample testing. I stand by the claim that commodity equity risk is just more beta with more noise.

  • mike

    Great article. When 54% in gov bonds in suggested, is there any specific way to play this? Is a bong fund best?

  • dph

    Wes,

    Are there any ETFs accessible to retail investors that mix equities and commodity futures and thus have a smoother return profile (in theory). Or does this need to be handled white glove for BIG accounts. It’d be nice for equity drawdowns to be mitigated by commodity futures especially if the portfolio (or ETF) knows to tilt toward that if equities reach certain triggers on extreme value or movement. .

  • sixchickensleft

    What’s a “bong fund”? Is that for a really severe market crash?

  • Yes, you forget the drawdown even happened and decide to eat cheetohs that day.

  • Hannibal Smith

    Nice summary! Managed futures are definitely a different beast than pure “buy and hold” spot and roll yields; typically they’ve been trend following instead so you get a muted fat tail. Virtually all of the commodity indexes are “buy and hold”, but one or two is trend following and so is about a handful of funds (none of which have attracted much attention). Fortunately, the whole enchilada of thorny issues involved with commodity indexing has finally been solved by RA.

    If you look at the chart under “Commodity Future Returns versus Other Assets Across Regimes” above, it’s pretty obvious that only one asset is best for different regimes. For commodities, it is high inflation. But as highly correlated cost inputs to a business, commodites are subject to expansion and recession risks which makes them inferior substitutes to holding stocks or bonds during such regimes. So just drill down into individual commodities to find out exactly what the high inflation outperformers are. There is a paper that illustrated per commodity returns during different regimes.

  • trr

    Wow, you’ve dug deep into this. I’d love to hear a response from the GMO authors, but I guess that’s unlikely.

    I’m now (stubbornly) wondering how to get the best of both worlds…. maybe dual momentum GUNR/USCI (and SHY).

    Happy holidays.