(John Kemp is a Reuters market analyst. The views expressed are
By John Kemp
LONDON Jan 4 Commodity markets are
becoming more efficient at processing information about current
supply/demand conditions and expectations about the future. But
in the process, excess returns captured by investors for
assuming price risk are vanishing.
The poor performance of first-generation passive commodity
indices since 2005 is well known as the extra money allocated to
the asset class has eroded roll returns. But there is some
evidence returns on second- and third-generation indices with
dynamic rolls and commodity allocations are also starting to
evaporate as more money chases them.
"Commodity markets are coming of age," according to a recent
research note by Citigroup. "Simple strategies to make money in
commodities are no longer likely to yield good returns.
"Our guess is that this is down to the massively increased
investment in the asset class in recent years, which has driven
returns lower," according to the bank's global strategy team.
Citigroup based its conclusions on a dynamic strategy of
filtering a set of commodity futures for roll returns and then
again for momentum before buying the five with the best roll and
momentum and selling the five worst ("Global Macro Strategy -
Commodity markets are becoming ever more efficient", Jan. 3).
According to the Citi strategists, "returns in the April to
December 2008 period were 40 percent, in the 2009 calendar year
were 22 percent, in 2010 were 9.5 percent and in 2011 were 5.4
percent. Every year, the return seems to halve."
BACK-TESTING AND ACHIEVABLE RETURNS
The Citi findings are intuitively plausible. They are also
consistent with the observed changes in commodity prices and
futures curves since investing in the asset class started to
become popular in 2005.
Charts 1 and 2 show long-run returns on a diversified
first-generation index (the GSCI Light Energy Index) and two
dynamic indices that could be considered second- or
third-generation products (the SummerHaven Dynamic Commodity
Index and the Deutsche Bank Liquid Commodity Index Mean
Reversion Enhanced strategy)
Since the 1990s, dynamic strategies have vastly outperformed
passive allocations. Chart 3 shows the degree of outperformance
persisted in the early years of the commodity investment boom
(2005-2008). But as Chart 4 illustrates, outperformance has
vanished since the beginning of 2009. Dynamic strategies have
been no more successful in delivering excess returns than their
passive counterparts in the last three years.
Dynamic indices are suffering the classic back-testing
problem. Index creators mined data on past futures prices to
select the strategy that maximises returns. But once investors
started to implement the resulting strategies, the pricing
anomalies that were the source of the historic returns vanished.
No one was actually implementing dynamic index strategies in
the 1990s, when the back-fitted index data show impressive
gains. In the mid-2000s, only a very small amount of money was
tracking these strategies; most investors were still using
Once returns on passive indices started to disappoint from
2008, and significant amounts of money were allocated to dynamic
strategies or hedge funds, returns on dynamic strategies
promptly collapsed. Once a significant number of investors tried
to exploit market inefficiencies, the inefficiencies
RISK PREMIUMS AND MARKET EFFICIENCY
The academic literature is divided about the theoretical
nature of expected returns to investors in commodity futures.
Some treatments emphasise the concept of hedging pressure
(more producers than consumers seeking to hedge their price
risk) resulting in "normal backwardation". Others focus on the
idea of a risk premium investors capture from hedgers.
In practice, there is little difference. All approaches
suggest hedgers (on net) must pay a premium to investors to
encourage them to assume unwanted price risk.
In their famous paper on "Facts and Fantasies about
Commodity Futures", published in 2004-2005, Gary Gorton and
Geert Rouwenhorst characterised the excess return over bonds as
a "risk premium". They found that an investment in a fully
collateralised equal-weighted basket of commodity futures
between 1959 and 2004 provided about the same return as
But their study seems to have suffered from its own
back-testing problem (or fallen victim to its own success). For
most of the period Gorton and Rouwenhorst studied, commodity
markets were small and illiquid, with only a relatively small
volume of investment. Returns to investors were correspondingly
But once the asset class became popular, more investors were
chasing the same source of returns, liquidity increased and
Increased market efficiency is expected. But we need to be
careful what we mean. Efficiency means less persistence and
predictability in both outright prices and term structure (roll
returns), which is what has undercut both the first-generation
and second/third-generation products.
It does not mean markets are infallible at predicting the
future or even that they are terribly rational in how they react
to news in the short term. Markets are social communities, not
mathematical models. As John Maynard Keynes understood (but many
of his successors appear to have forgotten), markets are voting
machines, not weighing machines.
FASTER PRICE DYNAMICS
Most participants at the recent OPEC-IEA International
Energy Forum in Vienna agreed oil (and other commodity) prices
could be driven by speculation in the short term, over-reacting
to developments with mini-bubbles and crashes, but were firmly
anchored by fundamentals in the long term.
No one was able to define what was meant by short term and
long term. Presumably the short term is reflexively defined as
the period when prices are driven by speculative factors, while
the long term is whatever time period over which fundamentals
But if oil and other commodities do suffer from price
anomalies in the short term, the short term may be getting
shorter. Certainly there is statistical evidence that markets
are becoming more forward-looking, such as in studies by
economists at the U.S. Commodity Futures Trading Commission.
They also appear to discount future changes in supply and demand
more quickly than before.
As a result, it is becoming harder to make confident
predictions (even dubiously accurate ones) about what will
happen to prices or curve structures.
Even most big commodity trading firms, the supposed experts,
deny taking "directional" views on prices, arguing they have no
better than a 50:50 chance of being right, and insist they are
fully hedged and focus instead on curve structure and
In oil, "few traders are venturing firm price predictions
due to the large tail risks" on both sides of the market at
present, according to my colleague Javier Blas at the Financial
Times ("Traders fear tail risks in commodities", Jan. 3).
While some analysts believe risks are currently tilted
towards the upside, on balance, and are unusually large, the
implied volatility surface for WTI and Brent options shows a
more even distribution.
Oil and other commodity markets are becoming increasingly
integrated with equities and other assets, as well each other,
as they move faster than ever before to incorporate economic
developments. Oil and gas markets are moving aggressively to
price medium-term supply shifts as well as short-term political
The last few years have seen a sterile (and inconclusive)
debate between commentators who believe commodity markets are
efficient and driven purely by fundamentals, and those who
believe price moves are exaggerated and driven mostly by
speculative froth. Like most divisions in economics, it mirrors
views about whether markets should be more tightly regulated or
But recent research and Citi's analysis suggests a middle
way between these theological extremes. It suggests that
commodity markets remain imperfect and inefficient, subject to
strange enthusiasms and frenzies, but the massive influx of
investment in recent years may actually have made them less
inefficient than before.
Unfortunately, improved efficiency may actually be to the
detriment of many investors, who have successfully traded away
many of the anomalies on which their strategies depended.
(editing by Jane Baird)