The Long and Short of Commodity Indexes

Abstract

The long-only strategies that currently dominate the commodity index market do not best serve investors as investment vehicles or as benchmarks. Since futures price changes and roll yields are the sources of excess return for commodity indexes, long-only indexes have no way to capture the returns available from shorting futures when there is downward price pressure or a positively sloped futures price curve. Long-only indexes generate negative roll yields when markets are in contango and thus can have negative returns when commodity prices are rising. Furthermore, since many actively managed commodity trading advisors (CTAs) invest in long and short futures based on momentum trading rules, the long-only indexes are not appropriate benchmarks, rendering traditional approaches to representing beta exposure unsuitable. By using a momentum-based approach that takes into account both price change and the slope of the futures price curve, long/short indexes aim to maximize both sources of excess return—price change and roll yield—to produce better performance. In addition, these indexes are logically consistent with the underlying economics of commodities futures markets, and back-tested results show an attractive risk profile, low downside risk, and low correlations to both traditional asset classes and long-only commodity indexes. As passive investment alternatives, these rules-based indexes could offer easier access to actively managed commodities trading strategies.